False Diagnoses: Pitfalls of Testing for Asymmetric Information In Insurance Markets

The widely applied ‘positive correlation test’ concludes that there is symmetric information in an insurance market if observationally identical buyers of high and low cover contracts have the same loss rate. As standard assumptions imply that only full‐cover contracts are bought when information is symmetric, a contradiction arises. The existence of a variety of contracts can be reconciled with symmetric information by claim‐processing costs but existing tests are then shown to fail. Ignoring the nature of loading factors may also cause recent studies to mismeasure the welfare costs of asymmetric information but these errors can be rectified.