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The two margin problem in insurance markets can be avoided

September 23, 2019

Topics: Quote of the Day

By Michael Geruso, Timothy J. Layton, Grace McCormack, and Mark Shepard
National Bureau of Economic Research, September 2019


Insurance markets often feature consumer sorting along both an extensive margin (whether to buy) and an intensive margin (which plan to buy). We present a new graphical theoretical framework that extends the workhorse model to incorporate both selection margins simultaneously. A key insight from our framework is that policies aimed at addressing one margin of selection often involve an economically meaningful trade-off on the other margin in terms of prices, enrollment, and welfare. For example, while a larger penalty for opting to remain uninsured reduces the uninsurance rate, it also tends to lead to unraveling of generous coverage because the newly insured are healthier and sort into less generous plans, driving down the relative prices of those plans. While risk adjustment transfers shift enrollment from lower- to higher-generosity plans, they also sometimes increase the uninsurance rate by raising the prices of less generous plans, which are the entry points into the market. We illustrate these trade-offs in an empirical sufficient statistics approach that is tightly linked to the graphical framework. Using data from Massachusetts, we show that in many policy environments these trade-offs can be empirically meaningful and can cause these policies to have unexpected consequences for overall social welfare.

From the Introduction

Some of the most important problems in health insurance markets stem from adverse selection, or the tendency of sicker consumers to exhibit higher demand for insurance. Concerns about adverse selection have motivated a variety of regulatory interventions in the U.S. and around the world, including insurance mandates, penalties for being uninsured, subsidies for purchasing insurance, risk adjustment transfers, benefit regulation, and reinsurance. Policy discussions about how to address adverse selection have become salient in the U.S. as many public programs have shifted toward providing health insurance via regulated markets.

But, a deeper look reveals that not all policies combating adverse selection are targeted at the same problem. Policies such as mandates and subsidies combat selection on the extensive margin (or “against the market”). This type of selection is characterized by sicker people being more likely to buy insurance. It leads to higher insurer costs and higher consumer prices and causes some healthy people to opt out. Policies such as risk adjustment and benefit regulation, on the other hand, combat selection on the intensive margin (or “within the market”). This type of selection is characterized by sicker people being more likely to purchase more generous plans within the market. Intensive margin selection drives up the price of generous plans relative to skimpy ones and results in too many consumers choosing skimpy plans. In some cases, selection within the market may be so strong that generous contracts cannot be sustained, and the market for them unravels entirely.

In this paper, we generalize the canonical insurance market framework to address both margins simultaneously. The benefit of doing so is not merely a technical curiosity. It has first-order policy importance in settings like the ACA Marketplaces where both the generosity of coverage and rates of uninsurance are serious concerns. To see why, consider an insurance mandate—a policy that aims to correct extensive margin selection by bringing healthy marginal consumers into the market. Our framework shows how a mandate that succeeds in increasing rates of insurance coverage will likely worsen selection on the intensive margin. Intuitively, the mandate brings more healthy/low- cost consumers into the market. Because these new consumers tend to select the lower-price (and lower-quality) plans, the risk pools of those plans will get even healthier. In equilibrium, these plans will further reduce prices, siphoning additional consumers away from higher-quality plans on the intensive margin, causing prices for high-quality coverage to spiral upwards. These two offsetting effects (improving take-up and inducing within-market unraveling) represent a clear example of the intensive/extensive margin interactions that are the focus of our paper.

Our insights about cross-margin interactions are relevant for active policy debates in the ACA and other insurance settings. For example, recently states have been given increasing flexibility to weaken ACA Essential Health Benefits or risk adjustment transfers (intensive margin policies)—with the stated goal being to lower plan prices and reduce uninsurance (a cross-margin effect). On the other hand, state efforts to simplify enrollment, auto-enroll certain consumers, or enact mandate penalties (all extensive margin policies) may create unintended consequences on the intensive margin. More broadly, our model is also relevant to other settings with two selection margins, including the Medicare program (with its Medicare Advantage option), employer programs with a plan choice decision and a participation decision (e.g., CalPERS), national health insurance systems with an opt-out (e.g., Germany), other insurance markets such as auto insurance and long-term care insurance where both the intensive and extensive margins may be important, and other non-insurance markets like consumer credit where there is evidence of both extensive and intensive margin risk selection.

From the Conclusion

Adverse selection in insurance markets can occur on either the extensive (insurance vs. uninsurance) or intensive (more vs. less generous coverage) margin. While this possibility has been recognized for a long time, most prior treatments of adverse selection focus on only one margin or the other. This focus misses important cross-margin trade-offs inherent to many selection policies.

Specifically, (1) strengthening uninsurance penalties can help some consumers by getting them into the market while hurting other consumers by inducing them to enroll in lower-quality coverage, and (2) strengthening risk adjustment transfers can help some consumers by inducing them to enroll in higher-quality coverage while hurting other consumers by forcing them out of the market. Additionally, we find that price-linked subsidies for low-income consumers can weaken some of these trade-offs (i.e. effects of risk adjustment and benefit regulation) but not others (i.e. mandates/uninsurance penalties). Finally, we show that trade-offs related to risk adjustment are often more pronounced when the advantageously selected plan has a cost advantage.

Because many policies lead to coverage gains on one margin and coverage losses on the other, in some cases the unintended effects of policies are first-order with respect to welfare. We show cases in which the welfare losses from coverage losses on the unintended margin exceed welfare gains from coverage gains on the intended margin. This happens most often with a penalty for choosing to be uninsured.

The issues we highlight here are relevant for future reform of the individual health insurance markets in the U.S. Many have observed that the overall quality of coverage available to consumers is low in these settings, with most plans characterized by tight provider networks, high deductibles, and strict controls on utilization. Additionally, others have observed that take-up is far from complete, with many young, healthy consumers opting out of the market altogether and choosing to remain uninsured. These two observations are consistent with adverse selection on the intensive and extensive margins, respectively. Our framework highlights the unfortunate but important conceptual point that budget-neutral policies that target one of these two problems are likely to exacerbate the other due to the inherent trade-off between extensive and intensive margin selection. This point is often absent from discussions of potential reforms by policymakers and economists, and our intention is to correct this potentially costly omission.



By Don McCanne, M.D.

Okay, this is another one of those mundane technical papers from academics in the policy community. But you really don’t have to wade through the intricacies of their treatise to understand the important point they make.

They consider the interactions of two margins in insurance markets: 1) the extensive margin that guides people on whether or not to buy insurance, and 2) the intensive margin that guides individuals on which plan to buy. Adverse selection, which concentrates higher cost individuals into segregated risk pools, can occur at either margin: 1) being insured or uninsured, or 2) having more generous versus less generous coverage. They show that a favorable shift in either margin can result in an unfavorable shift in the other. That is, efforts to expand the number of people insured at one margin can result in less generous coverage for those act the other margin. Likewise, efforts to expand benefits at the other margin can result in more people remaining uninsured.

It is easy to see that these adverse consequences are a direct result of our politicians and the policy community insisting on maintaining our highly fragmented system of financing health care through a plethora of private and public insurance programs. Currently their support of employer-sponsored plans and private Medicare Advantage plans are prime examples. Imagine if we had one single universal risk pool; adverse selection disappears. Automatically including everyone in an improved Medicare program means that nobody would be left uninsured and that everyone would have the same comprehensive package of essential health care benefits.

It is perplexing that these economists state that their their intention is to correct the potentially costly omission in the failure to recognize the inherent trade-off between extensive and intensive margin selection, almost as if they are saying, “deal with it, stupid, take your choice.” Yet they remain totally silent on the obvious solution of the single payer model of Medicare for All, in which you could have both truly universal coverage and comprehensive benefits for all.

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About the Commentator, Don McCanne

Don McCanne is a retired family practitioner who dedicated the 2nd phase of his career to speaking and writing extensively on single payer and related issues. He served as Physicians for a National Health Program president in 2002 and 2003, then as Senior Health Policy Fellow. For two decades, Don wrote "Quote of the Day", a daily health policy update which inspired HJM.

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