Preference Heterogeneity and Insurance Markets: Explaining a Puzzle of Insurance

David M. Cutler, Amy Finkelstein, Kathleen McGarry

NBER Working Paper No. 13746
Issued in January 2008
NBER Program(s):Economics of Aging, Health Care, Public Economics

Standard theories of insurance, dating from Rothschild and Stiglitz (1976), stress the role of adverse selection in explaining the decision to purchase insurance. In these models, higher risk people buy full or near-full insurance, while lower risk people buy less complete coverage, if they buy at all. While this prediction appears to hold in some real world insurance markets, in many others, it is the lower risk individuals who have more insurance coverage. If the standard model is extended to allow individuals to vary in their risk tolerance as well as their risk type, this could explain why the relationship between insurance coverage and risk occurrence can be of any sign, even if the standard asymmetric information effects also exist. We present empirical evidence in five difference insurance markets in the United States that is consistent with this potential role for risk tolerance. Specifically, we show that individuals who engage in risky behavior or who do not engage in risk reducing behavior are systematically less likely to hold life insurance, acute private health insurance, annuities, long-term care insurance, and Medigap. Moreover, we show that the sign of this preference effect differs across markets, tending to induce lower risk individuals to purchase insurance in some of these markets, but higher risk individuals to purchase insurance in others. These findings suggest that preference heterogeneity may be important in explaining the differential patterns of insurance coverage in various insurance markets.

download in pdf format
   (88 K)

email paper

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w13746

Published: David M. Cutler & Amy Finkelstein & Kathleen McGarry, 2008. "Preference Heterogeneity and Insurance Markets: Explaining a Puzzle of Insurance," American Economic Review, American Economic Association, vol. 98(2), pages 157-62, May. citation courtesy of

Users who downloaded this paper also downloaded* these:
Cohen and Siegelman w15586 Testing for Adverse Selection in Insurance Markets
Cawley and Philipson w5669 An Empirical Examination of Information Barriers to Trade in Insurance
Einav, Finkelstein, and Cullen w14414 Estimating Welfare in Insurance Markets Using Variation in Prices
Fang, Keane, and Silverman w12289 Sources of Advantageous Selection: Evidence from the Medigap Insurance Market
Einav, Finkelstein, and Levin w15241 Beyond Testing: Empirical Models of Insurance Markets
NBER Videos

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email:

Contact Us