Heterogeneity, Demand for Insurance, and Adverse Selection

Recent evidence underlines the importance of demand frictions distorting insurance choices. Heterogeneous frictions cause the willingness to pay for insurance to be biased upward (relative to value) for those purchasing insurance, but downward for those who remain uninsured. The paper integrates this finding with standard methods for evaluating welfare in insurance markets and demonstrates how welfare conclusions regarding adversely selected markets are affected. The demand frictions framework also makes qualitatively different predictions about the desirability of policies, such as insurance subsidies and mandates, commonly used to tackle adverse selection. (JEL D11, D81, D82, G22, G28)