How Adverse Selection Affects the Health Insurance Market

Abstract

There may be a price to pay (in terms of inefficient coverage) if competition among health insurers is encouraged as a way to give patients greater choice and to achieve better control over insurance providers. Adverse selection can be defined as strategic behavior by the more informed partner in a contract against the interest of the less informed partner(s). In the health insurance field, this manifests itself through healthy people choosing managed care and less healthy people choosing more generous plans. Drawing on theoretical literature on the problem of adverse selection in the health insurance market, Belli synthesizes concepts developed piecemeal over more than 20 years, using two examples and revisiting the classical contributions of Rothschild and Stiglitz. He highlights key insights, especially from the literature on equilibrium refinements and on the theory of second best. The government can correct spontaneous market dynamics in the health insurance market by directly subsidizing insurance or through regulation; the two forms of intervention provide different results. Providing partial public insurance, even supplemented by the possibility of opting out, can lead to second-best equilibria. The same result holds as long as the government can subsidize contracts with higher-than-average premium-benefit ratios and can tax contracts with lower-than-average premium-benefit ratios. Belli analyzes the following policy options relating to the public provision of insurance: - Full public insurance. - Partial public insurance with or without the possibility of acquiring supplementary insurance and with or without the possibility of opting out. In recent plans implemented in Germany and the Netherlands, where competition among several health funds and insurance companies was promoted, a public fund was created to discourage risk screening practices by providing the necessary compensation across risk groups. But only objective risk adjusters (such as age, gender, and region) were used to decide which contracts to subsidize. Those criteria alone cannot correct the effects of adverse selection. Regulation can exacerbate the problem of adverse selection and lead to chronic market instability, so certain steps must be taken to prevent risk screening and preserve competition for the market. Belli considers the following three policy options for regulating the private insurance market: - A standard contract with full coverage. - Imposition of a minimum insurance requirement. - Imposition of premium rate restrictions. This paper - a product of Public Economics, Development Research Group - is part of a larger effort in the group to improve social service delivery in developing countries. The author may be contacted at pbelli@hsph.harvard.edu or pbelli1@worldbank.org.