Asymmetric Information and Health Insurance

In this video, we discuss asymmetric information, adverse selection, and propitious selection in relation to the market for health insurance. Health insurance consumers come in a range of health, but to insurance companies, everyone has the same average health. Consumer have more information about their health than do insurers. How does this affect the price of health insurance? Why would some consumers prefer to not buy health insurance at all? And how does this all relate to the Affordable Care Act? Let’s dive in.

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- [Professor Tyler Cowen]
In the previous video,

we introduced the ideas
of asymmetric information,

and adverse selection
and we applied those ideas

to the used car market.

Let's take those same
basic concepts,

and build a basic model
of health insurance.

Suppose that potential
health insurance consumers

come in a range of states of health.

For instance,
the least healthy people

might cost about $30,000 a year.

That's these folks here.

The most healthy might cost
nothing in healthcare.

That's these folks over here.

Now consumers know this information,

but by assumption, insurers don't.

From the insurer point of view,

everyone is of the same
average health.

Here again, we have
asymmetric information.

That is consumers of healthcare

have more information about

their health status
than insurers do.

In this scenario, insurers have to
price the coverage

based on the average cost
among all consumers,

namely, $15,000.

But if the insurance costs $15,000,
then a portion of the market,

the relatively healthy people,

they will choose not
to buy insurance as

the cost of that insurance
is greater to them

than the expected benefit.

So only part of this market
will buy insurance.

The average cost of those
who actually will buy

is then not $15,000 but $22,500.

In that case,
the insurance company,

if it tries to price at $15,000,
loses money.

If the insurance company instead
raises the price to $22,500,

well, the same dynamic
is actually going to kick in again.

That is relatively healthy people

won't find it worth
paying that price.

The sicker people still will buy,

and that will raise
the expected costs

to the insurer,
and thus the price even further.

This dynamic continues
until the individual insurance firm

finds there is no price
at which it can attract

a set of customers with
healthcare costs

lower than the price of insurance.

This is the same death spiral
we saw before with used cars

and it leads to a market failure.

As we saw in the used car market,

there are several reasons
why reality may differ

from the simple model.

First, the model we laid out would
predict that the healthy people,

those who exercise,
eat their veggies,

and buckle their seatbelts would
not buy insurance,

while the model is predicting that
the smokers, the mountain climbers,

and the motorcycle riders would
buy insurance.

Is this true? Mostly no.

The people who buy health insurance

actually turn out to be
the healthier people as well.

Why is that?

Well, those who try to avoid risk
by eating well

also try to avoid risk
by buying health insurance.

Our initial assumption that

everyone calculates
costs and benefits

in exactly the same way
is too simple.

Once you account for the fact that

people have differential
tolerances for risk,

you can end up having
the healthier people be

those who choose to buy
the health insurance.

This is called
“propitious selection”

where the people who buy
the health insurance are healthier,

not sicker than average.

This can keep costs low,
and prevent the death spiral.

Another possible response
to the adverse selection problem

in health insurance
might seem familiar.

If you recall,
we saw that services such as

CARFAX and Certified Inspections

can alleviate
the asymmetric information problem

when buying a used car.

These services allow
the buyer of the car

to have similar information

to that possessed
by the seller of the car.

The result of this information
is that better cars

can sell for more,
and lemons can sell for less.

Is there an analogous approach
for people in health insurance?

Well, yes.

The health of people
can be inspected

just as cars are inspected.

So while consumers initially
may have more information

about their health than what
the insurance companies have,

a checkup will allow
the insurance firms

to get a better idea of
the consumer's expected

healthcare costs.

And that allows
the insurance companies

to charge healthy consumers less
and sicker consumers more.

In the used car market,

that seemed like
a pretty good solution.

After all, better cars
should sell for more,

and lemons should sell for less.

In the health insurance market,

that solution might work,

but some people feel it is
doubly unfair.

Not only are the sick sick,

but now they also have
to pay more

for their health insurance.

Another problem
with inspection is that

it might reveal
too much information,

thereby rendering health insurance
no longer viable.

For instance, let's say there's
a very good diagnostic test,

and it determines that
a patient A has cancer

and then B we know that cancer
will cost $1 million to treat.

Well, to insure against that cancer,

the price of the policy
has to be about $1 million,

but that's no longer insurance.

That's just presenting the patient
with the bill.

Insurance is protecting against
unexpected states of affairs,

and it's a kind of risk pooling,

a kind of protecting yourself
against the high bill.

But if you're getting the high bill
no matter what when you're sick,

well, then we've lost
those benefits of insurance.

Another solution to
the adverse selection problem

when used extensively
in the United States

is group health insurance
through employers.

Most people in America
don't purchase insurance directly.

Instead, their employer
purchases it for them

as part of a group plan.

The benefit of the system is that
the insurance company

doesn't have to worry about
adverse selection so much

The employer doesn't know much
more about its employees' health

than does the insurance firm.

Furthermore, the employer is
going to be buying

health insurance for the employees
regardless of their health.

So for these reasons,
the adverse selection problem is

much weaker with
group health insurance.

Group health insurance, however,
does cause other problems.

If you lose your job,
you can lose your health insurance.

And what we do about retirees?

In the United States,
various laws have made

health insurance more affordable,

and furthermore retirees are insured
by the government

under Medicare.

So, there are some solutions,
albeit imperfect ones as usual.

The most recent approach
to the adverse selection problem

was implemented
in the Affordable Care Act,

otherwise known as Obamacare.

Under the Affordable Care Act,

everyone is supposed to buy
health insurance.

If you don't,
you will be fined by law.

The idea here is to force
all the healthy people into the pool

of those who buy insurance

that will moderate the cost
of health insurance,

and we will avoid the death spiral.

As you can see, although

the adverse selection model
is pretty simple,

it has lots of applications

to some pretty complex
real-world problems.

Next up we'll tackle moral
hazard. See you then.

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