Two essays on long-term care insurance

One of the empirical regularities found in industrial organization literature is that industrial innovators typically develop persistent long-run comparative advantages as evidenced by greater market share and profitability. The evidence on firm performance related to financial innovation is generally characterized by sparse data and weak empirical tests. In essay one we conduct a direct and rigorous examination of the effects of product innovation on firms' market share, prices, and profits using a unique database for the relatively new and rapidly growing market for long-term care insurance (LTC).; While we cannot generalize to all segments of the financial industry, our results for the LTC insurance market show that early product innovation is associated with significantly higher market share and that high market share insurers enjoy greater profit margins. The finding is consistent with the view that firms develop cost efficiency through early product innovation and this foster greater growth and profitability. We also find a significant and positive relation between market share and prices that suggests innovators gain market power. The evidence is consistent with product differentiation models that suggest innovators derive higher profit margins from the exercise of market power in markets with imperfect information and switching costs.; In essay two we test the implications of alternative multiperiod adverse selection models. While the study is primarily motivated by the inconclusiveness and limitations of existing empirical studies, it can also shed further light on the issue of how LTC insurers may benefit from early product innovations.; The theory on insurance contract design under multiperiod adverse selection remains inconclusive because different models tend to invoke very different assumptions regarding issues such as insurers' ability to commitment to long-term contracts. Models that assume insurers can commit to long-term contracts generally predict ex ante risk separation which is associated with price highballing on existing contracts. In contrast, models built on assumptions of no long-term commitment by insurers and insurer retention of private information indicate lowballing pricing behavior under pooling equilibrium.; In this study we first extend existing empirical work by performing more robust tests on temporal profitability. We use policy-specific data on cohorts of policyholders who are initially classified under the same risk class based on observable risk characteristics. Our results on LTC insurance policy profitability are consistent with no-commitment models that predict price lowballing. We also conduct a direct test of temporal price adjustment. Consistent with the price lowballing prediction, we find that insurers adjust prices more fully in response to new information that indicates policyholders are of higher risk.; Thus, both our indirect test of insurer temporal profitability and direct test of temporal prices show that the characteristics of LTC insurance data fit the descriptions of those multiperiod adverse selection models that predict risk pooling with price lowballing when insurers cannot commit to long-term contracts. Also, this evidence of price lowballing, which is associated with insurers' ability to capture economic rents from established, existing customers, sheds additional light on the potential sources of gains to early entrants in LTC insurance market. (Abstract shortened by UMI.)...