Adverse selection in the UK annuity market and the 1956 Finance Act

This paper proposes a new price test for evidence of active adverse selection in the insurance market for longevity risks: the annuity market. The test is applied to the exogenous change in taxation of annuity payments following the UK’s 1956 Finance Act using a unique dataset of individual annuity contracts, and provides a natural experiment of whether the fall in annuity prices caused by the tax change induced marginal annuitants with higher mortality into the market after the tax change. We find some evidence to support an adverse selection story that mortalities of the pool of annuitants after the change increased. However, we also find that the story is more complicated because the tax change stimulated the development of annuity products that allowed higher mortality individuals to signal their mortality to annuity providers, creating a separating equilibrium, where previously there had only been a pooling equilibrium.

Keywords: Adverse selection, insurance markets, annuities
JEL codes: G22, D4, D82