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Unlucky or Risky? Unobserved Heterogeneity and Experience Rating in Insurance Markets

We investigate whether an insured's claims experience contains valuable information about its latent risk type. Using data on households' claims histories in auto and home insurance, we estimate the variance-covariance matrix of unobserved heterogeneity and utilize the estimates to update a priori predictions about the households' claim risk. The estimates reveal that unobserved heterogeneity is positively correlated across coverages. We then explore how households' demand for insurance would respond to experience rating under different theories of risky choice, and we discuss what our findings imply about the economic consequences of legal restrictions on experience rating.