Reflection Paper on these two chapters
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Chapter10.pptCHAPTER 10
ADVERSE SELECTION IN REAL MARKETS
Bhattacharya, Hyde and Tu – Health Economics
Intro
- Recall our example: a man walks into the office of a life insurance company.
- He wants to buy a $1 million life insurance policy for a term of one day. Your company will have to pay $1 million to his heirs if and only if he dies tomorrow.
- You know nothing else about this man.
- How much do you charge?
Ch 10 | Adverse selection in real markets
PREDICTIONS OF ASYMMETRIC INFORMATION MODELS
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Bhattacharya, Hyde and Tu – Health Economics
Asymmetric information models make three predictions about these markets
Positive correlation between risk and coverage
Bulk markups
Adverse selection death spiral
Bhattacharya, Hyde and Tu – Health Economics
1) Positive correlation between risk and coverage
- Recall Rothschild-Stiglitz:
- Separating equilibrium high-risk types have full insurance (Ω1), low-risk types have incomplete insurance (Ω2)
Bhattacharya, Hyde and Tu – Health Economics
2) Bulk markups
- Bulk discounts– a lower per-unit price for a large purchase of a commodity
- Bulk markups– a higher per-unit price for large purchases of a commodity
- Insurance companies use bulk markups to protect themselves from risk customers who want a lot of insurance
- This is exactly what the Rothschild-Stiglitz model predicts
Bhattacharya, Hyde and Tu – Health Economics
3) Adverse selection death spiral
- Both frail and robust individuals are pooled together
- Premium is average cost of people in the pool
- Frail types are indirectly subsidized by robust
- Robust types exit the pool, leaving only unhealthy individuals
- Cycle repeats
- Readjusted premium
- Healthier types leave
Ch 10 | Adverse Selection in Real Markets
ADVERSE SELECTION IN HEALTH INSURANCE
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Bhattacharya, Hyde and Tu – Health Economics
Empirical evidence for adverse selection in health insurance markets
- RAND HIE
- Individuals are able to predict their health care costs for the year to a good degree of accuracy
- Specifically, they are able to predict health care costs more accurately than insurance companies
- Families with high predicted costs were more likely to want supplemental insurance
Bhattacharya, Hyde and Tu – Health Economics
Empirical evidence for adverse selection in health insurance markets
- Several studies find a positive risk-coverage correlation in various markets
- Brown and Finkelstein 2009 (elderly US Medicare beneficiaries)
- Van de Ven and van Vliet 1995 (Dutch supplemental private insurance)
- Cutler and Zeckhauser 1998 (Harvard professors)
- Spenkuch 2012 (low-income Mexican families)
- Cardon and Hendel 2001 (young graduates joining US workforce)
Bhattacharya, Hyde and Tu – Health Economics
Empirical evidence for adverse selection in health insurance markets
Bhattacharya, Hyde and Tu – Health Economics
Empirical evidence against adverse selection in health insurance markets
- US workers with employer-sponsored insurance (2001)
- Positive correlation disappears when adjust for age, race, and gender
- Medicare beneficiaries (2008)
- Negative correlation
- Maybe “advantageous selection”
- Seniors with greater cognitive ability are healthier and more likely to purchase supplemental insurance
Ch 10 | Adverse selection in real markets
ADVERSE SELECTION IN OTHER MARKETS
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Bhattacharya, Hyde and Tu – Health Economics
Adverse selection in other types of insurance markets
- Automobile insurance
- Positive risk-coverage correlation in Israel, but not France
- Life insurance
- Bulk discounting (not markups) in life insurance market for teachers
- Negative risk-coverage correlation: people with life insurance live longer!
- Viatical settlements
- What is a viatical settlement? A firm purchases a life insurance contract from a sick person, then collects the payout when he dies.
- Adverse selection theory suggests that relatively healthy HIV patients should sell their insurance contracts more readily, but this was not the case in the early 1990s viatical settlement market in the US.
Ch 10 | Adverse selection in real markets
WHAT PREVENTS ADVERSE SELECTION?
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Bhattacharya, Hyde and Tu – Health Economics
Why would adverse selection not occur?
Four main reasons:
- Customers misperceive their own risk
- Customers do not act on their private information
- Insurers can accurately observe customer risks
- “Advantageous selection”
Bhattacharya, Hyde and Tu – Health Economics
Why would adverse selection not occur?
- Customers misperceive their own risk
- US and Swedish novice drivers demand less insurance
- 88% of US students believe they are safer than median driver
- What is the chance that a man aged 85-89 will live to 100?
- US survey respondents aged 85-89 reported an average subjective probability of 31%
- Mortality tables indicate the answer is about 3.4% for US
- What is the chance that a woman aged 70 to 74 will live to 85?
- US survey respondents aged 70 to 74 reported a subjective probability of 51%
- Mortality tables indicate the answer is about 57% for US
Bhattacharya, Hyde and Tu – Health Economics
Why would adverse selection not occur?
- Customers do not act on their private information
- Real customers have more important things to think about than small bargains on insurance
- Customers may fail to realize their advantage
- Car owners can predict how many miles they will drive in the coming year with good accuracy
- Yet, they do not seem to take that into account when deciding how much insurance to purchase
Bhattacharya, Hyde and Tu – Health Economics
Why would adverse selection not occur?
- Insurers can accurately observe customer risks
- Long-term care insurers, with access to historical data and a team of analysts, are better at predicting whether middle-aged customers will eventually need nursing home care than the customers themselves
- In the pre-HAART days, viatical settlement firms could accurately predict HIV life expectancy from a simple blood test
- Remember that all of our models rest on an assumption of information asymmetry
Bhattacharya, Hyde and Tu – Health Economics
Why would adverse selection not occur?
- “Advantageous selection”
- Sometimes it is healthier, less risky people who are more likely to buy insurance
- Why?
- more risk averse
- higher income
- better understanding of insurance benefits
- Why?
- Fang (2008) show that cognitive ability is
- positively correlated with Medigap insurance purchase
- Negatively correlated with health expenditures
Bhattacharya, Hyde and Tu – Health Economics
Heterogeneous risk preferences
- Assuming homogenous risk types and heterogeneous risk preferences:
- Negative correlation: between risk and coverage
- Bulk discounts: will exist to encourage people to buy more insurance
- No death spiral with insurance pooling: people who are more risk averse will stay in the pool when premiums rise but will still be the same risk type to the insurer
Bhattacharya, Hyde and Tu – Health Economics
Conclusion
- Akerlof and RS models make specific predictions about how insurance markets will look.
- Evidence confirms these predictions in some markets, not in others.
- Adverse selection is crucial to understanding the challenges of health policy.
