Question

3. Identify the information problems that lead to market failure in health insurance markets. Define the two concepts “moral hazard” and “adverse selection.” Describe separately how the existence of each affects the market for health insurance and medical care. What are some of the ways that insurance companies try to protect themselves against these two phenomena?

6. What is meant by private splendor and public squalor?

Answer 1

Answer to question no. 3:

The information problems that lead to market failure in health insurance markets are as follows:

Information asymmetry can occur when one party in a health insurance market transaction knows more than the other party relating to cost or price. Asymmetry means lack of equality between parts of something.

• Let us suppose that, A is an insurance company (insurer) and B is the prospective policy holder. A might lack knowledge about expected utilization of information which B might possess. This situation might lead to adverse selection.
• Moreover, B may know more about the value of the insured services he has availed of, the knowledge of which insurer A may lack. It leads to moral hazard.
• The health insurance service provider might have more knowledge than the insurer about cost and quality. This leads to inefficiency in reimbursement.

Moral Hazard: Insurance is a contract of good faith between the insurer and the insured. It may happen that the insured intentionally takes additional risks or does not take any precaution to mitigate the risk knowing that he is fully protected and the loss will be completely borne by the insurer. This situation is know as moral hazard. Moral hazard generally exists after starting of the policy.

Adverse Selection: When a prospective policy holder has some more information or some advantage about a product as compared to the insurer, he may seize the opportunity due to lack of information of the insurer, it is called adverse selection. Adverse selection generally exists prior to the starting of the policy.

Effects of moral hazards in health insurance market:

As the insured is taking additional risks intentionally or not taking any precaution to mitigate the risk, the insurer is bearing the inflated cost of health services and spending more money towards payment of the claims. It is, in turn, putting an impact on the profitability of the insurer. As a result, the cost of the health services (i.e. premium of the health insurance) is increasing to match up with the increased expenses.

Effects of adverse selection in health insurance market:

Adverse selection happens when person with higher risk or people with more illness, buy health insurance but people with good health is not taking policy that much comparatively. It also happens when people with more illness buy health insurance plans with wider benefits. It results in a higher risk for the insurer to lose money by the way of paying more claim amount that they had predicted. Here also, to match the expenses, the insurer will increase the premium of health insurance and as a repetitive process, adverse selection is also increasing as people with good health is not taking policy due to increased premium.

Steps that insurance companies take to protect themselves from moral hazard:

• Insurance companies require the insured party to bear a share of the cost. This means, that the insured has to bear a small amount before the insurance coverage starts. This is known as copayment.
• If the insurer gets to know that there has been some kind of fraud from the part of the insured, it may prosecute the insured legally.
• The insurer may put some loading in the renewal premium to prevent the moral hazard. Otherwise, a discount in premium can also be given to for good claim experience.
• Insurer can provide some incentives to the health care providers for communicating proper information about any policy to the insured. So that, there is no gap in the information.

Steps that insurance companies take to protect themselves from adverse selection:

• The health insurance policies are to be priced properly. It means, the insurer has to take proper actuarial decision about setting up the premium of any health policy. In order to reduce exposure to large claims, the insurer can raise premium and/or limit the coverage.
• The health risks are to be spread properly among all kind of insured such as exposure by location wise, class wise, size and line of business wise. The groups of people who are more risk-prone to health hazards, would pay more amount of premium.
• Risk selection and underwriting rules is being improved. The underwriters analyze the medical examination report of the applicant which helps the insurer to understand the current health of the applicant and the possibility of paying a claim. This helps the insurance company to decide whether to accept the risk or not and what premium to charge.