Equilibria in Health Exchanges: Adverse Selection vs. Reclassification Risk

Article Source: Working paper, The Toulouse Network for Information Technology (TNIT), July 3, 2012
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Time to Read: 2 minute read
Written By:

 Ben Handel

Ben Handel

 Igal Hendel

Igal Hendel

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This paper suggests that the Affordable Care Act will have a positive effect on health insurance markets.


Policy Relevance:

In health insurance markets, a consumer’s difficulty in obtaining a new insurance policy after developing an expensive condition is more harmful than the pricing distortions that result when firms are not able to charge consumers on the basis of their risk factors.


Key Takeaways:
  • The Patient Protection and Affordable Care Act will require US states to create health insurance “exchanges”, menus of health insurance plans that consumers may purchase with government support.
    • In these exchanges, insurance providers will only be able to set prices on the basis of a few factors like age, and may not refuse to provide insurance on the basis of preexisting conditions.
    • Insurance policies sold through exchanges are a year in duration.

  • In economic theory, health insurance markets have two well-known problems.
    • When insurers can’t charge a consumer more for insurance when he or she has a risky trait because they can’t observe the trait (or because law prohibits it), consumers with that trait will buy excessive amounts of insurance. This is the adverse selection problem in health care.
    • By analogy, if a reckless driver is able to buy car insurance at the same price as a safe driver, he may decide to buy a large policy as he is likely to get in a crash; this would make it difficult for car insurance providers to operate efficiently.
    • Consumers who cannot buy lifetime insurance policies are unable to protect themselves from large premium increases if they develop expensive conditions over the term of an insurance policy. This is the reclassification risk.
    • Economic theory predicts that PPACA’s policies will result in more adverse selection but will solve the problem of reclassification risk.

  • A quantitative model calibrated using employee health insurance data from a large firm provides support for the hypothesis that PPACA will worsen adverse selection problems in health insurance markets.

  • In a novel finding, the same model suggests that in the long term reclassification risk is a bigger problem for consumers than is adverse selection.



Michael Whinston

About Michael Whinston

Michael D. Whinston is the Sloan Fellows Professor of Management in the Applied Economics Group at MIT Sloan and Professor of Economics in the Economics Department. His research has covered a variety of topics in microeconomics and industrial organization, including firm behavior in oligopolistic markets, antitrust, game theory, the design of contracts and organizations, law and economics, and most recently health economics.