Life Insurance: Nudges and Adverse Selection

Death of a breadwinner can have devastating financial consequences on surviving dependents through lost earnings and medical expenses. Life insurance is designed to help mitigate these financial burdens. Nonetheless, there are documented shortages in life insurance coverage. Adverse selection---where higher risk individuals are more likely to purchase coverage leading to market failure---could be one of the causes of uninsured vulnerabilities. I analyze both the existence of and welfare costs from adverse selection in individual term life insurance and employer-sponsored life insurance (ESLI) at a large public university. In the individual term market, using a representative sample of purchasers, I do not find evidence of adverse selection in general likely due to extensive underwriting conducted by insurance companies. In contrast to term life insurance, ESLI does not individually underwrite life insurance policies. This in conjunction with the ability of employees to increase coverage annually without health screening and the existence of term life insurance as a substitute make ESLI at the university highly susceptible to adverse selection. Despite these vulnerabilities, I do not find evidence of economically significant adverse selection in general. Nonetheless, the most highly educated employees---faculty members---do exhibit significant adverse selection. These results together suggest that a lack of financial sophistication likely keeps the ESLI market from unraveling. Other possible explanations include the availability of accelerated death benefits, employee inertia, and financial complexities in comparing group and individual coverage. In addition to analyzing the efficiency of the life insurance markets, I analyze the effectiveness of a policy designed to increase life insurance coverage. Using data from a large public university, I analyze a policy change that increased basic life insurance coverage and expanded coverage options for employees. The increased coverage represented a nudge for employees with supplemental coverage. In large part due to inertia, the nudge increased life insurance holdings one-for-one for those who could have undone it. Additionally, I find that expanding coverage options significantly increased total life insurance holdings for new hires who were not subject to inertia. The increased basic coverage and expanded options reduced uninsured vulnerabilities for two-thirds of employees. These findings have important policy implications for addressing widespread disparities in life insurance coverage