Risk Awareness and Adverse Selection in Catastrophe Insurance: Evidence from California's Residential Earthquake Insurance Market

Abstract

How does catastrophe-risk awareness affect selection patterns in catastrophe insurance markets? Catastrophe insurance is often provided by government entities and frequently involves substantial cross-subsidization between people facing very different levels of risk, which could generate adverse selection problems. Yet there is also ample evidence that people have low understanding and awareness of catastrophe risk, which could prevent people from exploiting their informational advantage. I study this issue using data on take-up rates of earthquake insurance in California, where there is both a semi-public insurer using very coarse geographic risk classification and private insurers who price at a finer level. I find that within the same rating territory, there is a positive correlation between risk and take-up for insurance, suggesting that people have some meaningful awareness of their risk and act on it in ways consistent with adverse selection. However, despite substantially different risk-classification schemes, the positive correlation is similar for both the public and private insurers. This suggests that while awareness of risk is linked to the decision to purchase insurance, people are not basing their insurance decisions on comparisons of risk and insurance prices in a way that would lead to stronger adverse selection when rates are cross subsidized.