qotd: Information frictions - good for insurers, bad for patients

The National Bureau of Economic Research
November 2015
NBER Working Paper No. 21759
Information Frictions and Adverse Selection: Policy Interventions in
Health Insurance Markets
By Benjamin R. Handel, Jonathan T. Kolstad, Johannes Spinnewijn

Abstract

A large literature has analyzed pricing inefficiencies in health
insurance markets due to adverse selection, typically assuming informed,
active consumers on the demand side of the market. However, recent
evidence suggests that many consumers have information frictions that
lead to suboptimal health plan choices. As a result, policies such as
information provision, plan recommendations, and smart defaults to
improve consumer choices are being implemented in many applied contexts.
In this paper we develop a general framework to study insurance market
equilibrium and evaluate policy interventions in the presence of choice
frictions. Friction-reducing policies can increase welfare by
facilitating better matches between consumers and plans, but can
decrease welfare by increasing the correlation between
willingness-to-pay and costs, exacerbating adverse selection. We
identify relationships between the underlying distributions of consumer
(i) costs (ii) surplus from risk protection and (iii) choice frictions
that determine whether friction-reducing policies will be on net welfare
increasing or reducing. We extend the analysis to study how policies to
improve consumer choices interact with the supply-side policy of
risk-adjustment transfers and show that the effectiveness of the latter
policy can have important implications for the effectiveness of the
former. We implement the model empirically using proprietary data on
insurance choices, utilization, and consumer information from a large
firm. We leverage structural estimates from prior work with these data
and highlight how the model's micro-foundations can be estimated in
practice. In our specific setting, we find that friction-reducing
policies exacerbate adverse selection, essentially leading to the market
fully unraveling, and reduce welfare. Risk-adjustment transfers are
complementary, substantially mitigating the negative impact of
friction-reducing policies, but having little effect in their absence.

From the Conclusion

After establishing that information frictions have a substantial impact
increasing demand for generous coverage, we investigate the implications
of a policy that reduces the impact of information frictions (e.g.
through information provision). We find that a policy that reduces the
impact of information frictions by 50% reduces the market share of
consumers enrolling in more generous coverage from 85% to 73%, and that
a policy that fully removes information friction further reduces the
market share in generous coverage to 9% (with corresponding welfare
reductions). We illustrate that this negative impact of reducing
frictions occurs because the mean and variance of surplus are low
relative to the mean and variance of costs. We also show that as
friction-reducing policies become stronger, effective insurer
risk-adjustment transfers are more important. When frictions are fully
present, fully effective risk-adjustment increases the market share in
generous insurance from 85% to 88%, but when there are no frictions that
same risk adjustment policy increases this share from 9% to 64% (with
corresponding welfare increases).

http://www.nber.org/papers/w21759

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Comment by Don McCanne

At the risk of losing important subtleties in this technically complex
paper, I'll try to simplify it by saying that the more information that
a buyer has when deciding about the coverage of a plan (the goal of
transparency in the insurance markets), the greater the risk of adverse
selection (concentrating high cost patients in a plan), making
risk-adjustment transfers more imperative in order to shift costs from
plans enrolling more expensive high-risk patients to plans enrolling
less expensive low-risk patients. Without effective risk-adjustment
transfers, the market would unravel due to adverse selection.

Stated another way, information frictions (lack of information
provision, plan recommendations, and smart defaults that would improve
consumer choices) lead to suboptimal plan choices. More information
leads to better choices but increases adverse selection. Risk-adjustment
transfers have little impact when information frictions are fully
present (the insurance purchaser is in the dark), but risk-adjustment
transfers are essential when there are no frictions (fully informed
insurance purchaser).

What can we make of this? On the face of it, shopping in the dark is
bad. But the results of informed shopping require effective
risk-adjustment transfers to counter adverse selection. To date,
risk-adjustment processes (e.g., hierarchical condition categories) are
capable of correcting only about one-tenth to one-fifth of the
consequences of adverse selection. Since four-fifths or more of the
excess burden cannot be transferred by today's methods, we should be
concerned about the authors' finding that "friction-reducing policies
exacerbate adverse selection, essentially leading to the market fully
unraveling, and reduce welfare."

It is unlikely that risk-adjustment will improve significantly. The
insurers have already demonstrated how easy it is for them to game
risk-selection adjustments, and there is no end to their ability to
innovate.

The problem is really very simple. The private insurers, for their own
benefit, continue to impair the functioning of our health plans, and
then inflict upon us outrageous administrative charges for doing so.

The solution is simple. Replace them with a single payer national health
program. Patients would not have to shop plans since everyone would be
covered by the same single comprehensive plan. Patients would not have
to worry about information frictions, whether or not they understood them.