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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