“They do know what they are doing ... at least most of them.†Asymmetric Information in the (private) Disability Insurance*

In this paper we analyze asymmetric information in the (private) disability insurance, which has not been analyzed before in the literature, but covers one of the most important risks faced by individuals in modern society, namely the loss of human capital. We show that there is asymmetric information, but the extent depends on the amount of coverage. Most importantly, the test with ‘unused’ observables allows us also to establish the existence of adverse selection which is of importance for contract design and public policy. Moreover, the option of choosing an annual adjustment of the insured sum, which is not used for risk classification, has strong predictive power both for the occurrence of an accident and the chosen coverage, although it should be irrelevant from the point of theory. This result shows new ways to design contracts and variable selection for risk classification. In contrast to most previous studies, we also explicitly take into consideration unobserved heterogeneity by applying finite mixture models and so called ‘unused’ observables.