When economists notice that nobody sells insurance for X, they have a standard explanation: adverse selection. Why can’t you buy flood insurance? Supposedly, because the highest-risk people will be first in line to buy it, which raises premiums, which encourages low-risk people not to buy, which raises rates further, and so on. The market “unravels.”

This all sounds good on a homework problem, but it doesn’t fit the facts very well. Do homeowners around the country really know more about their flooding risks than the actuarial profession? It is particularly hard to stand behind the adverse selection story when insurers could condition rates on the best meteorological data, the age and elevation of the home, distance from water, and other simple statistics.

It is also worth mentioning that a number of recent empirical studies find that selection is more likely to be advantageous than adverse. Low-risk people often buy more insurance than high-risk people! Check out Cawley and Philipson on life insurance and Chiappori and Salanie on auto insurance.

What’s the real story? Here are a few ideas.

  1. Adverse selection runs the other way. If you got an offer for flood insurance in the mail, maybe you’d figure “They only offer it because it isn’t worth it.” I don’t find this too plausible, as long as the issuer is already reputable.
  2. The insurance just isn’t worth it. It costs a lot to fix a scratch on your car, but most of us can live with a scratch. Maybe flood damage is similar.
  3. Consumers underestimate these risks, so they mistakenly conclude insurance isn’t worth it. The problem here is that the uninsured risks (like flood) seem to get more news coverage than the insured risks (like auto accidents). So if anything you’d expect the bias to go the other way.
  4. People figure that the government will bail them out if there is serious damage, so there is no need to get their own insurance.

I don’t know which, if any, of these alternative theories are right, but I suspect it’s mostly a blend of #2 and #4. What I am pretty sure of, though, is that “adverse selection” is more a convenient slogan than a convincing explanation for missing insurance markets.