The Effects of Insurance Policy Limits on Product Choice

Abstract

Feldstein [5] and Pauly [ 14,15] have argued that excessive insurance, and in the extreme full insurance coverage, may lead to inefficient resource allocation. Specifically, insurance changes the out-of-pocket prices faced by the insured. The result of this transfer of risk from one agent to another and the associated reduction in the price is to induce increased resource use. Problems cited in the context are moral hazard and biased selection.' Moral hazard is defined as the over consumption of a good that results from the insured's indifference to price as a result of insurance coverage. Biased selection is the choice of a different bundle of goods than would have been chose in the absence of insurance coverage. Three alternatives have been proposed as solutions to the problems arising with full coverage: co-insurance, deductibles, and limits of coverage. All of these solutions require the insured to pay some portion of the goods' price. While co-insurance and deductibles have been frequently examined, both theoretically and empirically, limits of coverage have not been widely considered as a solution to the resource misallocation problem.2 This omission, however, may not be entirely unreasonable. Limits of coverage on the amount the insurer pays can impose a large burden on the