Adverse Selection and Moral Hazard: Implications for Health Insurance Markets

Abstract

This chapter explores two key issues in the health insurance market: adverse selection and moral hazard. It first describes ideal insurance to serve as a benchmark for comparing insurance in the presence of moral hazard and adverse selection. Given moral hazard, there is a rationale for high-deductible plans, such as the typical Health Savings Accounts, but the tax treatment of employer-provided health insurance benefits poses an impediment to the diffusion of such plans. These employee benefits are currently excluded from employees’ income for the purposes of the U.S. federal personal income tax. In contrast to moral hazard, adverse selection is a “paper tiger,” more important in theory than in practice in in health insurance. Nevertheless, adverse selection may be a significant phenomenon in other markets, depending on their specific characteristics. The chapter also considers the effects of cost sharing on health care.