Thursday, November 10, 2011
Posted by D. Daniel Sokol
Benjamin R. Handel addresses Adverse Selection and Switching Costs in Health Insurance Markets: When Nudging Hurts.
ABSTRACT: This paper investigates consumer switching costs in the context of health insurance markets, where adverse selection is a potential concern. Though previous work has studied these phenomena in isolation, they interact in a way that directly impacts market outcomes and consumer welfare. Our identification strategy leverages a unique natural experiment that occurred at a large firm where we also observe individual-level panel data on health insurance choices and medical claims. We present descriptive results to show that (i) switching costs are large and (ii) adverse selection is present. To formalize this analysis we develop and estimate a choice model that jointly quantifies switching costs, risk preferences, and ex ante health risk. We use these estimates to study the welfare impact of an information provision policy that nudges consumers toward better decisions by reducing switching costs. This policy increases welfare! in a naive setting where insurance plan prices are held fixed. However, when insurance prices change endogenously to reflect updated enrollee risk pools, the same policy substantially exacerbates adverse selection and reduces consumer welfare, doubling the existing welfare loss from adverse selection.