Adverse Selection Example

Byran Caplan: 

If an economist wants to ward off the spirit of laissez-faire insurance policy, all he has to do is repeatedly chant "moral hazard and adverse selection."  The funny thing about this two-part mantra, though, is that the "moral hazard" part doesn't do any of the work.  Almost no one even pretends that governments do anything to mitigate it.

When we get to the "adverse selection" part, the plot thickens.  There is, in theory, a regulation capable of solving the problem: mandatory insurance.  To see how mandates can help, consider a simple example.  Suppose there are two equally common types of people who buy insurance:

High-Risk Consumers: They have a 20% chance of losing $2000.  Since they're risk-averse, they value full insurance at $1000 ($600 more than the actuarially fair premium of $400).

Low-Risk Consumers: They have a 1% chance of losing $2000.  Since they're risk-averse, they value full insurance at $50 ($30 more than the actuarially fair premium of $20).

If insurance companies can't distinguish High- from Low-Risk consumers, an actuarially fair premium for an average consumer would cost .5*$400+.5*$20=$210. 

If consumers purchase insurance voluntarily, though, the Low-Risk will drop out of the market - they won't pay $210 to get a policy worth $50 to them.  With only High-Risk consumers in the market, the competitive price of a policy is $400.  The market fails to realize $30 worth of consumer surplus per Low-Risk consumer.

In a mandatory insurance regime, however, the Low-Risk have to buy the policy.  The result: The regulation is efficiency-enhancing, because it takes $160 from every Low-Risk person in order to give $190 to every High-Risk person.

All insurance produces moral hazard and the more generous the insurance, the more moral hazard it produces.  There is nothing government nor private insurance can do about that except by reducing the generosity of insurance coverage.  I agree with Caplan that moral hazard isn't that much of a problem in health care.  The adverse selection problem comes down to ethics.  For example, insurers want to charge women more than men because women are prone to expensive pregnancies.  Most people think that that is unfair and so governments regulate insurance to subsidize pregnancies by making men pay more than the free market would require.  Adverse selection also causes a race to the bottom on quality of care because insurers want to get rid of sick people and that is another equity problem.  If insurers could only insure healthy people, they would be more profitable, but the whole point of insurance is to help sick people and adverse selection means that healthy people try to get out of helping the sick.  Most people do not object if bad drivers must pay high insurance fees for their recklessness (although we do want them to get insurance because of the externalities), but most people do object when sick people die because insurance companies do not want to cover them.