Liquidity Constraints and the Value of Insurance
Insurance affects the variability of consumption over time, which is not captured in standard expected utility of wealth models. We develop a consumption-utility model that shows how liquidity constraints and borrowing costs impact the value of insurance. Liquidity constraints generate high insurance demand when premiums are due smoothly, sometimes leading to seemingly dominated choices. Conversely, a risk-averse person may value insurance below its expected value and appear risk loving when premiums are due in a single payment. Moreover, optimal insurance contracts take different forms with liquidity constraints. We show empirical insurance analysis using the standard model can generate misleading counterfactuals and welfare estimates. Finally, we demonstrate the model’s feasibility and importance with an application to evaluating cost-sharing reductions on the health insurance exchanges.
We thank Jason Abaluck, Nikhil Agarwal, Jacob Bor, Marika Cabral, Randy Ellis, Amy Finkelstein, Neale Mahoney, Michaela Pagel, Jim Rebitzer, and Jeremy Tobacman for helpful comments, as well as workshop participants at Boston University, the BU-Harvard-MIT Health Seminar, the National Bureau of Economics Summer Institute, the University of Pennsylvania’s Behavioral Economics and Health Symposium, the University of Texas, and the University of Wisconsin, Madison. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.