Taming risk selection in competitive insurance markets

Competitive markets make companies offer competitive pricing for their products - but this might play out differently in certain markets, like insurance markets impacted by adverse selection. In his latest paper published in Journal of Mathematical Economics, Anastasios Dosis, Professor of Economics at ESSEC Business School, discusses the impact of competition and risk selection in markets, particularly insurance markets, and evaluates different policies that aim to mitigate risk.

Certain policies are used to adjust risk, like risk adjustment or minimum insurance requirements - however, these often mean that young, healthy people (deemed low-risk) go uninsured. As a result, policy makers implement policies to expand insurance to those populations. This has led to rising health insurance premiums across the United States and elsewhere, begging the question: are there alternative policies that correct risk selection without undermining the competition?

To answer that question, Dosis evaluated the effectiveness of price cap regulation as a means to eliminate risk selection without undermining competition. Price caps have been put forward as a solution to these pricey premiums, with policy makers and economists suggesting that these can correct market failures while still allowing the market to function (i.e. Chernew et al., 2019). His model focused on general insurance markets with adverse selection, where companies offer different types of plan.

The article presents a model with insurance companies and consumers, where companies propose price schedules as well as price caps. The final price was the minimum between its price schedule and competitors’ price caps: if its plan’s price was above the price cap, the price would be adjusted to that level.

The analysis reveals that price caps limit profitable deviations by firms and allow efficient and individually rational allocations to be sustained. If regulators have access to this information, they can then set price caps without relying on the companies, but this is typically not the case and they instead need to rely on the companies’ transparency. The advantage of the model used here is that the companies set their price caps without reliance on such a central authority (i.e., in a decentralized manner), mimicking real-world conditions more closely. This model demonstrates that price cap regulation reduces risk selection, allowing the economy to reach efficient risk sharing. Further, the proposed price cap regulation doesn’t undermine efficient competition.

Implementation

When it comes to implementation, Dosis notes that electricity, higher education, telecommunications and healthcare are already typically regulated by price caps. For example, France currently has a price cap on electricity due to skyrocketing inflation. While insurance is tightly regulated, the variety of plans available complicates the picture. However, Professor Dosis suggests that one strategy could be the introduction of a step where companies propose the plans all companies should offer, then the price cap adjustment as described in the model takes place.

Reference
Dosis, A. (2022). Price caps and efficiency in markets with adverse selection. Journal of Mathematical Economics, 99, 102591.