Information frictions - good for insurers, bad for patients

Information Frictions and Adverse Selection: Policy Interventions in Health Insurance Markets

By Benjamin R. Handel, Jonathan T. Kolstad, Johannes Spinnewijn
The National Bureau of Economic Research, November 2015

NBER Working Paper No. 21759


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).



By Don McCanne, M.D.

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.