How Adverse Selection Affects the Health Insurance Market

The paper discusses the consequences of adverse selection on the functioning of health insurance markets using two examples and presents a survey of existing theoretical literature. To isolate the effects of adverse selection from other confounding factors, the paper considers a benchmark situation with no moral hazard and perfectly competitive market. It analyses different policy options to correct spontaneous market dynamics, either by direct public provision of health insurance or by regulation of private insurers. It tries to provide a unitary representation of a set of concepts that have developed piece-meal over a period of more than twenty years and looks at government intervention. The author concludes that:

• Regulation of the private insurance market by imposition of a standard contract or by restricting premium rates, on the other hand, can exacerbate the problem of adverse selection and lead to chronic market instability;
• The government can intervene in the health insurance market by directly subsidizing insurance or by regulation.