Testing for Asymmetric Information in the Automobile Insurance Market Under Rate Regulation

Abstract This article examines whether adverse selection or moral hazard could be induced by rate regulation, which prohibits insurance companies from considering some attributes of drivers in setting premiums. Using an individual data set from a heavily regulated automobile insurance market, we arrived at several conclusions, as follows. First, no evidence of adverse selection or moral hazard is found in general: conditional on all the variables observed by insurer, the null hypothesis of independence between risk and coverage is not rejected at reasonable levels of statistical significance. Second, this result is robust in the sense that it holds under several empirical procedures and different definitions of risk and coverage. Third, we find that unobserved variables do not induce adverse selection: the null hypothesis that consumers in risky regions are more likely to purchase insurance is tested against the alternative and rejected. Our study supports the view that the adverse selection phenomenon exists only to a very limited extent in this market.