Question

This issue of adverse selection exists in health insurance market because there is asymmetric information between insurers and individuals

a) Explain what this "information asymmetry" means - i.e, which party (the insurer or the individual) has more information about what

b) Explain why "information asymmetry" in health insurance market could lead to "death spiral" - i.e as more and more individuals drop out of the insurance market, the market might collapse in the end.

Answer 1

(a) Information symmetry refers to imperfect knowledge about a commodity between the people in a transaction. It occurs when one transactor has more information than the other. In the case of health insurance, the individual has more information about his health than the insurer. This may lead to adverse selection i.e. this unequal information distorts the market and leads to market failure. How? the death spiral.

(b)

A health insurance death spiral describes a scenario in which premiums increase rapidly, causing healthy people to drop their coverage when they perceive that it's no longer worth the cost. That, in turn, causes premiums to increase even more, as the exodus of healthy people leaves a smaller, less healthy risk pool. As premiums continue to increase, healthier people continue to drop their coverage, and the situation continues to spiral until it reaches a point where the market simply collapses.

This is a result of asymmetric information. When someone conceals his information about their health conditions (to attract lower premium rates), they are placed in a low risk pool than they should actually be in. This is exactly what asymmetric information means. Now, they pay lower premium to cover their health charges, however, it raises the average premium rate for entire risk pool as the insurer is occuring greater expenditure on health of those who concealed information. The genuinely healthy ones feel that they are over paying and don't find such high premiums worth the cost. Thus, the healthy individuals drop out leaving a larger concentration of sick people in the group (these are the ones who "may" have concealed information in the beginning). However, with time, even these sick people think that now that rates are already so high, why not drop out of this and get a better costlier policy? And thus, the market failure unfolds.

The collapse happens when coverage is too expensive for anyone to afford, and/or the insurers opt to exit the market altogether. Insurers generally only want to remain in markets that are fairly stable. And for an insurance market to be stable, the majority of the members in the insurance pool have to be relatively healthy, so their premiums can offset the cost of caring for the sickest members of the pool.

Thanks!