Question

5. Suppose health status ("healthy" or "unhealthy") represents asymmetric information: Each individual knows her or his health status, but insurance companies do not.  

Now, suppose an insurance company offers only two types of policies: 1) a full-coverage policy with premium equal to the most expensive (regardless of insurance type) of the two full-coverage policies.

a. In the boxes below, calculate expected utility for a "healthy" individual, for each scenario:

No Insurance:

Most Expensive Full-Coverage Policy (Option 1):

Least Expensive Deductible Policy (Option 2):

b. In the boxes below, calculate expected utility for an "unhealthy" individual, for each scenario:

No Insurance:

Most Expensive Full-Coverage Policy (Option 1):

Least Expensive Deductible Policy (Option 2):

c. Based on your answers in 5a. and 5b., which option would a representative member of each group (i.e. "healthy" and "unhealthy") choose?

d. In the box below, enter the insurance company's expected economic profit from selling the desired policy (from the individual's perspective) to a member of each group.

Expected Profit from "Healthy":

Expected Profit from "Unhealthy":

Answer 1

Definition of adverse selection

Adverse selection occurs when there is asymmetric (unequal) information between buyers and sellers. This unequal information distorts the market and leads to market failure.

• For example, buyers of insurance may have better information than sellers. Those who want to buy insurance are those most likely to make a claim. Therefore firms are reluctant to sell insurance.
• Sellers of second-hand goods may have better information about the true quality of the good than buyers. Therefore, buyers are reluctant to pay a decent price because they fear getting a ‘dud’.

Adverse selection occurs because of information asymmetries and the difficulties in selecting customers.

Adverse selection in insurance results in-

• People choose inappropriate or inadequate coverage because they do not understand the

complex information in the policies.

• People choose too much coverage because they do not understand the complex

information in the policies.

• People choose too little coverage because they do not understand the complex

information in the policies.

• Unhealthy people become more likely to buy insurance than healthy people, which

drives premiums up, which drives even more healthy people away from the market.

• Healthy people become more likely to buy insurance than unhealthy people, which

drives premiums up, which drives even more unhealthy people away from the market even though they are the ones who need it most.

For Example

Julia is a 28-year-old nonsmoking, non-drinking female of normal weight. Because of adverse selection in health insurance,
A) She will be charged less for her premiums than people who are higher risks.
B) She is less likely to buy health insurance than the average person, because policy
premiums are based on expected medical expenditures of people who are less healthy
than she is.
C) When she get health insurance, she will be less likely to take care of herself.
D) She must get health insurance early in life, and is likely to lose health insurance if she
smokes, drinks to excess, or gains weight.
E) She is more likely than the average person to buy health insurance, because she is more
likely to be offered it.

Consequences of adverse selection

• Due to poor information and difficulty selecting customers, there will be a higher overall price as firms have to take into account relatively higher payouts to high-risk customers taking out insurance.
• Low-risk customers may not want to buy because it istoo expensive for their needs – leading to a missing market.
• Firms may invest considerable time in identifying which groups of consumers are higher risk.

Adverse selection in health insurance

Suppose an insurance firm offered health insurance to the general public. It is likely to have the highest take-up rate amongst unhealthy people – people who don’t exercise, people who smoke. They are the group most likely to need health care; therefore, it makes sense for them to take out insurance. Healthy people are less likely to take out health insurance – if the price of health insurance is determined by the average unhealthy person.

If insurance premiums are based on the needs of smokers, then the premiums will be high. Therefore, there is no incentive for healthy people to take out insurance.

Solutions to adverse selection

To avoid adverse selection, firms need to try and identify different groups of people. This is why there are health insurance premiums for people who smoke and obese people.

Insurance firms will charge different rates to consumers depending on factors, such as

• Age
• Postcode.

This means that those who are at most risk will likely have higher premium rates.

Compulsory purchase

American health care is primarily based on private insurance. This has led to problems of adverse selection, with young, healthy people more likely to avoid taking out health insurance. This led to higher overall premiums – making it unaffordable for many.

One element of the Affordable Health Care act was to have a compulsory insurance element. If people choose not to take out insurance, they have to pay a tax premium. The idea is that by encouraging people to purchase, it will lower overall premiums as people with lower-risk will join the ‘insurance pool.’