If insurance companies can’t tell the difference between high-risk consumers and low-risk consumers, then the low-risk consumers will drop out of the market and go uninsured. Low-risk consumers won’t pay what the insurance companies ask, because they don’t expect to lose anywhere near as much as the insurance companies expect them to lose:
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 (0.5*$400) + (0.5*$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.
If, on the other hand, we make insurance mandatory, then we can actually improve the efficiency of the insurance market — by making the low-risk consumers pay more than they would pay, but less than the high-risk consumers gain through the rigmarole:
The regulation is efficiency-enhancing, because it takes $160 from every low-risk person in order to give $190 to every high-risk person.
Some people will see the mandatory-insurance scenario as more fair; others will see it as much, much less fair.
Bryan Caplan takes a closer look at adverse selection and mandatory insurance though, and he finds something very different from the theoretical model:
When you actually look at these regs, you’ll notice some peculiarities:
- 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.
- 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.
- 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.
- 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.