State-Dependent Utility and Insurance Purchase Decisions

Jeffrey R. Brown, Gopi Shah Goda, Kathleen McGarry

NBER Retirement Research Center Paper No. NB 13-06
Issued in September 2013

A standard result of most economic models of insurance is that optimizing individuals will equate the marginal utility of consumption across various states of the world. Under certain stylized conditions – including state-independent preferences – a standard benchmark is that consumption smoothing via full insurance is optimal. With regard to health risks, however, it is occasionally posited (but infrequently modeled) that preferences might be state dependent. Although recent empirical evidence has suggested that preferences may differ with health state, there has been little empirical work correlating cross-sectional differences in state dependence with differences in insurance demand. In this paper, we use a novel survey-based measure to document substantial cross-sectional heterogeneity in the degree of state dependence with regard to health, and show that this heterogeneity is largely orthogonal to other observable individual characteristics. We further show that there are small but significant differences in state dependence with regard to mental and physical impairments. Finally, we show how our measures of state dependence are related to insurance purchase.

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