Information Frictions and Adverse Selection: Policy Interventions in Health Insurance Markets

Abstract

This paper develops and implements a general framework to study insurance market equilibrium and evaluate policy interventions in the presence of choice frictions. Friction-reducing policies can increase welfare by facilitating better matches between consumers and plans, but can decrease welfare by increasing the correlation between willingness-to-pay and costs, exacerbating adverse selection. We identify relationships between the underlying distributions of consumer (i) costs (ii) surplus from risk protection and (iii) choice frictions that determine whether friction-reducing policies will be on net welfare increasing or reducing. We extend the analysis to study how policies to improve consumer choices interact with the supply-side policy of risk-adjustment transfers and show that the effectiveness of the latter policy can have important implications for the effectiveness of the former. We implement the model empirically using proprietary data on insurance choices, utilization, and consumer information from a large firm. We leverage structural estimates from prior work with these data and highlight how the model's micro-foundations can be estimated in practice. In our specific setting, we find that friction-reducing policies exacerbate adverse selection, essentially leading to the market fully unravelling, and reduce welfare. Risk-adjustment transfers are complementary, substantially mitigating the negative impact of friction-reducing policies, but having little effect in their absence.

The Questionable Value of Having a Choice of Levels of Health Insurance Coverage

“…Consumer mistakes in selecting health plans can have two effects, as discussed in Handel (2013) and formalized in Handel, Kolstad, and Spinnewijn (2015). On the one side, mistakes lead people to sort less optimally between plans, which can lower welfare.…”

Heterogeneity, Demand for Insurance, and Adverse Selection

“…In contrast with previous work, the focus in this paper is on heterogeneity in behavioral frictions and how this underlies the demand for insurance. Using the framework with heterogeneous frictions, Handel, Kolstad, and Spinnewijn (2015) study their interaction with pricing inefficiencies in employer-provided health plans and evaluate the positive and normative implications of demand and supply side interventions.…”

Selection in Health Insurance Markets and Its Policy Remedies

“…It involves long-run risk (Cochrane 1995;Handel, Hendel, and Whinston 2015;Hendren 2017). Riskaverse consumers value not only coverage for fluctuations around their expected annual health spending, such as due to a broken bone; they also value coverage for health state transitions, such as developing diabetes, that may permanently affect their expected health care consumption and thus their health insurance premiums in the absence of premium rating regulations.…”

“…More than half of US households contain a member with a pre-existing condition (Kaiser Family Foundation 2016). Calibrations by Handel, Hendel, and Whinston (2015) suggest that the welfare benefits of eliminating reclassification risk may swamp the welfare costs of one-period adverse selection. While we feel obligated to bring attention to this understudied and important issue, we will focus here primarily on the interaction between policies like community rating that address this reclassification risk, and selection.…”

“…Additionally, it is important to understand that risk adjustment is intended to address intensive margin (high-versus lowcoverage) selection rather than the extensive margin (insurance versus uninsurance) selection problem depicted in Figure 2. Adapting the fixed contracts approach to the intensive margin problem, Layton (forthcoming) and Handel, Hendel, and Whinston (2015) show that conventional risk adjustment can eliminate most of the inefficiency caused by adverse selection across plans in a Marketplace-like setting, assuming consumers cannot opt out of coverage altogether. Handel, Kolstad, and Spinnewijn (2015) use a fixed contracts framework to show that risk adjustment can be complementary to policies that improve consumer choices, limiting the negative consequences of these choice-improving policies for adverse selection (Handel 2013).…”