Adverse Selection and the Insurance Market

Arnold Kling quotes a Cutler, Finkelstein and McGarry paper:

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.

The standard theory is largely a story of adverse selection due to asymmetric information - you know if you're healthy or a good driver, etc. but the insurance company does not - thus only higher risk people will be the ones buying the most insurance. Akerlof's Lemons Model, where the lemons are people.

I once had an economics professor tell me that the underlying assumption that people have more information than the insurance firms is, in most cases, demonstrably false. Most people lack the ability to accurately determine how much of a health risk they are or how bad their driving is. Being able to unbiasedly assess one's own characteristics is one of the hardest things a person can do. So the information asymmetry likely runs the other way - your car insurance company likely is a better judge of your driving abilities than you are.