Adverse Selection

What does the actuarially fair premium mean?

• It is defined as the premium where insurance premium = expected medical spending

• it is the expected payout (p x payout + (1-p) x 0).

What does symmetric information mean

insurers know the risk type of each individual (they know who is healthy and who is sick), just as the individuals know themselves.

How is the actuarially fair premium determined under symmetric information?

• The insurer charges a specific premium for each risk type that equals that type's expected medical spending

• Example: Healthy people are charged a low premium (e.g., $500), and sick people are charged a high premium (e.g., $2,500). There is no cross-subsidization.

What does asymmetric information mean? How does an insurer’s premium-setting decision change under asymmetric information?

• individuals know their risk type, but the insurer does not

• Premium Decision: Because the insurer cannot distinguish between types, they cannot charge different prices. Instead, they set a single pooled premium based on the average expected spending of the group seeking insurance.

What does the pooled premium mean? Is it actuarially fair to the insurer? How about to the insured individuals?

• The pooled premium is the average expected spending of the entire group (e.g., the average of $500, $1,000, $1,500, $2,000, and $2,500 = $1,500)

Is pooled premium actuarially fair to the insurer?

To the Insurer: Yes, it is actuarially fair because the total premiums collected equal the total expected payouts (assuming everyone buys).

Is pooled premium fair to the insured individuals?

To the Insured: No, it is generally not fair at the individual level due to cross-subsidization:

• Healthy types pay more than their expected cost (they subsidize the sick).

• Sick types pay less than their expected cost.

What does adverse selection mean, and how does it lead to a death spiral (adverse selection spiral)?

This occurs when lower-risk individuals leave the insurance pool because the pooled premium is higher than their expected medical spending.

Death Spiral

1) The healthiest individuals leave the pool.

2) This leaves a riskier pool of remaining individuals.

3) The insurer must raise the premium to cover the higher average cost.

4) The next healthiest group now finds the premium too high and leaves.

5) This cycle repeats until the market collapses or only the very sickest remain.

How does adverse selection play out in the five–risk-type example?

• With 5 types (costs: $500, $1k, $1.5k, $2k, $2.5k), the initial pooled premium is $1,500.

• The healthiest (cost $500) drop out because $1,500 > $500.

• New premium becomes $1,750 (average of remaining 4).

• The next healthiest (cost $1,000) drop out because $1,750 > $1,000.

• This continues until only the sickest ($2,500) remain or the market unravels completely.

How is consumer welfare affected by adverse selection and the resulting death spiral?

• Adverse selection causes a welfare loss.

• Healthy individuals who are risk-averse and would have valued insurance at a fair price are forced to go uninsured because of the inflated pooled premium.

What are the three ways to prevent adverse selection? What is a specific method used in reality for each?

1) Subsidize the price of insurance

• Tax credits (e.g., ACA subsidies) or employer subsidies to make insurance cheaper for healthy people so they stay in the pool.

2) Mandate insurance coverage

• Individual Mandate (tax penalties for not having insurance) prevents healthy people from opting out.

3) Direct provision of insurance (or Risk Rating/Segmentation)

• Government provision (e.g., Medicare/Medicaid) or allowing insurers to charge based on risk (though the slides emphasize mandates and subsidies as the primary market fixes).