Loss aversion leading to advantageous selection

Some insurance markets are characterized by “advantageous selection”, that is, ex-post risk and coverage are negatively correlated. We show that expectation-based loss aversion as in Kőszegi and Rabin ( Quarterly Journal of Economics, 121 (4), 1133–1165, 2006 ; The American Economic Review, 97 (4), 1047–1073, 2007 ) provides a natural explanation for this phenomenon in environments in which risk aversion models do not, e.g., when agents face modest-scale risks and/or in absence of moral hazard. More exposure to risk has two competing effects on an agent’s willingness to pay for insurance: a positive effect, as in standard expected utility models; and a negative one, due to a reference effect. We determine conditions under which an insurance provider optimally sets a high price at which only low risk agents buy.