TY - JOUR AU - Finkelstein,Amy AU - Poterba,James TI - Testing for Adverse Selection with "Unused Observables" JF - National Bureau of Economic Research Working Paper Series VL - No. 12112 PY - 2006 Y2 - March 2006 UR - http://www.nber.org/papers/w12112 L1 - http://www.nber.org/papers/w12112.pdf N1 - Author contact info: Amy Finkelstein Department of Economics MIT E52-274C 50 Memorial Drive Cambridge, MA 02142 Tel: 617/253-4149 Fax: 617/868-2742 E-Mail: afink@mit.edu James M. Poterba Department of Economics MIT, E52-350 50 Memorial Drive Cambridge, MA 02142-1347 Tel: 617/253-6673 Fax: 617/258-7804 E-Mail: poterba@nber.org M2 - featured in NBER digest on 2006-03-27 AB - This paper proposes a new test for adverse selection in insurance markets based on observable characteristics of insurance buyers that are not used in setting insurance prices. The test rejects the null hypothesis of symmetric information when it is possible to find one or more such %u201Cunused observables%u201D that are correlated both with the claims experience of the insured and with the quantity of insurance purchased. Unlike previous tests for asymmetric information, this test is not confounded by heterogeneity in individual preference parameters, such as risk aversion, that affect insurance demand. Moreover, it can potentially identify the presence of adverse selection, while most alternative tests cannot distinguish adverse selection from moral hazard. We apply this test to a new data set on annuity purchases in the United Kingdom, focusing on the annuitant%u2019s place of residence as an %u201Cunused observable.%u201D We show that the socio-economic status of the annuitant%u2019s place of residence is correlated both with annuity purchases and with the annuitant%u2019s prospective mortality. Annuity buyers in different communities therefore face different effective insurance prices, and they make different choices accordingly. This is consistent with the presence of adverse selection. Our findings also raise questions about how insurance companies select the set of buyer attributes that they use in setting policy prices. We suggest that political economy concerns may figure prominently in decisions to forego the use of some information that could improve the risk classification of insurance buyers. ER -