Question

Below is an excerpt from the abstract of a recent National Bureau of Economic Research working paper entitled "Adverse selection and switching costs in health insurance markets: when nudging hurts" by Benjamin Handel (2011):

This paper investigates consumer switching costs in the context of health insurance markets, where adverse selection is a potential concern ... We present descriptive results to show that (i) switching costs are large and (it) adverse selection is present. To formalize this analysis we develop and estimate a choice model that jointly quantifies switching costs, risk preferences, and ex ante health risk. We use these estimates to study the welfare impact of an information provision policy that nudges consumers toward better decisions by reducing switching costs. This policy increases welfare in a naive setting where insurance plan prices are held fixed. However, when insurance prices change endogenously to reflect updated enrollee risk pools, the same policy substantially exacerbates adverse selection and reduces consumer welfare, doubling the existing welfare loss from adverse selection.

Handel finds that providing information about health insurance plans to people can exacerbate adverse selection. Explain how barriers to switching health insurance plans can partially solve the adverse selection problem

Answer 1

Barriers to switching health insurance plans can mitigate the issue of adverse selection by maintaining a mix of high- and low-risk individuals within the same plan, reducing the possibility that only high-risk individuals will be insured. However, such barriers can also negatively affect consumer welfare by making it more difficult for individuals to change to better plans.

Step-by-step explanation:

The problem of adverse selection arises when there is asymmetric information between insurance buyers and insurers, where the buyers have more knowledge about their own health risks. Buyers who are high-risk tend to purchase more insurance without the insurers being fully aware of this increased risk. A way to mitigate adverse selection is by creating barriers for switching insurance plans, which can reduce the tendency of high-risk individuals to switch plans frequently to gain the most benefit, potentially while underreporting their risk. This can balance the risk pool by retaining a mix of high- and low-risk individuals in the same insurance plan, thus stabilizing the market and preventing price escalations that occur if only high-risk individuals are insured.However, it's also essential to consider that while barriers to switching can decrease adverse selection, they might also reduce consumer welfare by making it harder for individuals to find and switch to more suitable or cost-effective plans. The main answer to addressing the problem of adverse selection involves a combination of policy interventions, such as employer-based group insurance, mandates for individual insurance coverage, preventing denial based on preexisting conditions, and considering the impact of information provision policies on the market dynamics.