The Influence of Sellers on Contract Choice: Evidence from Flood Insurance

Abstract

We examine the ability of insurers to influence the coverage limit decisions of 180,000 households in the National Flood Insurance Program. In this program, private insurers sell identical flood contracts at identical rates and bear no risk of paying claims. About 12% of new policyholders overinsure, selecting coverage limits that exceed their home's estimated replacement cost. Overinsuring implicitly covers the risk that losses exceed the estimated replacement cost, a risk in which the seller has an informational advantage. Overinsuring is also expensive relative to expected loss, making it difficult to explain with standard decision-making models. The rate of overinsuring differs substantially across insurers, ranging from zero to one-third of new policies. Insurer effects are statistically significant after controlling for the insured's characteristics. Additionally, some insurers seem to encourage households to overinsure in percentage terms (e.g., buy 110% of replacement cost) while others encourage rounding up in dollars (e.g., to the next $10,000). Finally, we find that insurers' distribution systems and commission rates influence whether their policyholders overinsure. Our results show that insurers help select households' flood insurance contracts.