Risk-based Selection in Unemployment Insurance: Evidence and Implications (with C Landais, A Nekoei, P Nilsson and D Seim)

Abstract:
Despite the large existing literature on unemployment insurance (UI), the fundamental question why it is mandated, with no coverage choice available, remains unanswered. While adverse selection has long been recognized as hindering efficient market function, to date no direct evidence exists in the UI context and the desirability of a UI mandate is untested. Building on the unique institutional setting of Sweden, where workers can buy supplemental UI coverage above a minimum mandate, we provide the first direct evidence for risk-based selection in UI and of its implication for the design of social insurance against unemployment risk. First, we document a strong correlation between unemployment risk and the choice of buying supplemental coverage (with semi-elasticities around 1), even after controlling for a rich set of observables. Second, exploiting unique individual level variation in risk, we provide evidence for substantial risk-based selection, controlling for moral hazard. Third, using unique variation in the price of UI, we document that the average cost of UI increases with the price of UI. Despite the severe adverse selection, we find that the offered choice welfare-dominates mandating the supplemental coverage. We cannot reject that the subsidy for supplemental coverage is set optimally. We also explore the complementarity between the subsidy and mandating a minimum coverage level.