A Closer Look at Adverse Selection and Mandatory Insurance
By Bryan 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.
So far, so good. It’s conceivable for mandatory insurance regs to improve market performance. But their argument jumps the shark when defenders of government insurance regulation notice the existence of mandatory insurance regulations, and infer that these regs are doing something about adverse selection. When you actually look at these regs, you’ll notice some peculiarities:
1. Mandatory insurance is most prominent in the auto insurance industry. But these regulations don’t target low-risk drivers. Their main purpose, contrary to the adverse selection model, is to make sure high-risk drivers get insurance.
2. Even more shocking: The regulations usually go on to somehow subsidize the rates that high-risk drivers pay. This is necessary because, contrary to the adverse selection model, insurance companies are able to detect high-risk drivers, and do not want to cover them at a loss.
3. Economists usually mention adverse selection in the context of health insurance. But in the market for individual health insurance – precisely where you’d expect adverse selection problems to be most severe – governments very rarely mandate insurance coverage. Instead, they focus on mandatory employer-provided health insurance, where the adverse selection problem is likely to be milder.
4. When governments do mandate health insurance, they almost always subsidize the rates that high-risk buyers pay. This is once again necessary because, contrary to the adverse selection model, insurance companies are able to detect high-risk customers, and do not want to cover them at a loss.
Bottom line: Real-world insurance regulation has little or nothing to do with economists’ “moral hazard and adverse selection” mantra. The “intellectual” bases of real-world regulation of insurance are rather populism and paternalism: Big bad insurers won’t cover people unless it’s profitable, and simple-minded consumers don’t care enough about their own health to pay for it themselves.
Contrary to e.g. Krugman, insurance isn’t a “special” market where laissez-faire doesn’t work. Instead, it’s a normal market where democratic politics doesn’t work, because both the public and economists remain wedded to populism and paternalism.