WP 2017-03 Welfare Effects of Insurance Contract Non-Performance
ABSTRACT: Non-performance lies at the heart of much of the regulation that insurance companies face. We provide a behavioral evaluation of the welfare effects of non-performance risk, keeping close to the canonical theoretical framework of Doherty and Schlesinger . We find that there is a significant reduction in efficiency, our preferred measure of welfare in this instance, when there is non-performance risk. This measure does not just reflect the obvious fact that a less reliable product should be valued less by (risk averse) agents, ceteris paribus. Instead, efficiency normalizes the consumer surplus gains and losses from observed choices to naturally account for the fact that insurance that is subject to non-performance risk is a less reliable product than insurance that is free of that risk. Our results show that the compound risk characteristic of non-performance risk significantly decreases the welfare of insurance choices made by individuals. Violation of the Reduction of Compound Lotteries axiom by individuals is associated with significant reductions of welfare when there is a compound risk of loss, providing a structural behavioral insight to inform normative policy design. Take-up is not a reliable proxy for welfare. Those most vulnerable to nonperformance risk in our sample tend to be younger and black; Christians handle downside nonperformance risk efficiently compared to others.