Testing for Adverse Selection with "Unused Observables"
This paper tests for asymmetric information in the U.K. annuity market by trying to identify 'unused observables,' attributes of individual insurance buyers that are correlated both with subsequent claims experience and with insurance demand but that insurance companies historically did not use to set insurance prices. Unlike the widely-used positive correlation test for asymmetric information, which searches for a positive correlation between insurance demand and risk experience, the unused observables test is not confounded by heterogeneity in individual preference parameters that may affect insurance demand. We identify residential location as an unused observable in the U.K. annuity market of the late 1990s, and show that this variable is correlated both with annuity demand and with prospective mortality. Thus even though residential location is observed by all market participants, the decision not to condition prices on it creates the same types of market inefficiencies that arise when annuity buyers have private information about mortality risk. Our findings raise interesting questions about how insurance companies select the set of buyer attributes that they use in setting policy prices. In the decade following the period that we study, U.K. insurance companies have shifted their pricing practices to condition annuity premia on a buyer's postcode. We speculate on what leads firms to forgo the use of some information in risk classification.
This paper was revised on February 7, 2013