232 | Amy Finkelstein on Adverse Selection and Hidden Information
Apr 10, 2023
01:13:32
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Quick takeaways
Adverse selection in insurance markets leads to a race to failure as only the riskiest individuals tend to buy insurance, resulting in market failure.
Private information creates a selection problem for insurers, making it challenging to accurately price policies based on different risks customers pose.
Mandating insurance coverage and government intervention aim to mitigate adverse selection, but enforcement can be challenging and may lead to a game of cat and mouse with insurers.
Deep dives
The Fascinating Problem of Insurance Market Selection
Insurance markets face a unique challenge known as adverse selection, where only the riskiest individuals tend to buy insurance. This creates a race to failure, as insurers raise prices to cover the costs of high-risk customers, leading to only the sickest individuals purchasing insurance. This market failure is not due to greed, but a result of the inherent nature of insurance markets. Strategies such as raising prices or enforcing mandates have been attempted, but they have their own limitations and trade-offs.
The Role of Private Information in Insurance Markets
Private information plays a crucial role in insurance markets, as customers often know more about their health risks than insurers. This creates a selection problem where insurers struggle to accurately price policies based on the different risks customers pose. There is evidence that people's private information influences their insurance purchasing decisions, such as the higher rates of purchasing nursing home insurance among those at risk for genetic diseases. Despite advancements in big data, there are still unknown factors that individuals know about themselves that insurance companies cannot capture, further complicating the selection problem.
The Complexities of Mandates and Government Intervention in Insurance Markets
Mandating insurance coverage and government intervention in insurance markets aim to mitigate adverse selection and ensure everyone has access to affordable coverage. However, enforcing mandates can be challenging and may require penalties or subsidies to incentivize compliance. The government's attempts to regulate insurance markets can lead to a game of cat and mouse, with insurers finding ways to select favorable customers or loopholes in the system. The United States' approach to dealing with insurance market issues differs from other countries, but the solutions to improve the system are not simple and involve trade-offs.
The Importance of Behavioral Effects in Health Insurance
People who are willing to buy insurance at higher prices exhibit higher healthcare utilization after purchasing insurance compared to those who purchased at lower prices. This behavioral effect of insurance leads to increased healthcare use. Insurance companies have an interest in encouraging healthy behaviors, but offering gym membership bundles with health insurance does not lead to improved health outcomes. Instead, these bundles attract individuals who are already healthier. Behavioral effects and customer selection play a role in insurance dynamics.
Challenges in Assessing Risk and Pricing Insurance
Insurance companies rely on actuarial science to assess risk and price insurance premiums. However, uncertainty in risk assessment, especially for events like terrorism, poses challenges. Reinsurance is used to redistribute risk among insurers to mitigate the impact of concentrated risks. In insurance markets, insurers strive to understand their customers' risks and behaviors, while customers have a responsibility to disclose relevant information. Legal regulations vary regarding insurers' ability to discriminate based on risk factors. Empirical studies and randomized control trials are essential in evaluating the impact of policies, such as expanding Medicaid, and informing evidence-based decision-making in insurance.
If you knew exactly when every person was going to die, or require medical care, you could make a killing buying and selling insurance. Nobody knows these things, of course -- the future is hard to predict -- but some people know something about the future that other people don't. This sets up adverse selection: the ability of one party to leverage information another party doesn't have, in order to gain an economic advantage. Economist Amy Finkelstein is an expert in this phenomenon, as well as the usefulness of empirical studies in economic research.
Amy Finkelstein received her Ph.D. in economics from the Massachusetts Institute of Technology. She is currently John & Jennie S. MacDonald Professor of Economics at MIT. She is the co-director and research associate of the Public Economics Program at the National Bureau of Economic Research, and the co-Scientific Director of J-PAL North America. Among her awards are a MacArthur Fellowship and the John Bates Clark Medal. Her recent book, with co-authors Liran Einav and Ray Fisman, is Risky Business: Why Insurance Markets Fail and What to Do About It.
