Essays on adverse selection

This dissertation addresses the issues of adverse selection in the health insurance market. The literature on adverse selection focuses on consumer responses and their effects on pricing. In contrast to most previous literature, these essays consider not only the demand side but also the supply side of the health insurance markets in investigating the effect of adverse selection and relevant policies.

The first chapter provides evidence of the effects of adverse selection on insurers' behavior. I exploit the gradual implementation of risk adjustment from 2004 to 2007 in Medicare Advantage (MA). Under this policy, the government reimburses private insurers proportional to the health risk of their enrollees. I present evidence that benefit generosity and diversity of MA plans are responsive to the incentive of risk selection.

The second chapter develops and estimates an oligopoly model of MA to investigate the effects of adverse selection on welfare, allowing for endogenous benefit designs of insurance plans. I exploit information on plan-level average risk scores and market shares as well as plan characteristics from Centers for Medicare and Medicaid Services (CMS) to identify the demand for MA plans. My findings show adverse selection, which is based on the generosity of the benefits of MA plans. Specifically, high-risk consumers valued benefit generosity more than low-risk consumers did. The findings of the demand and cost estimates also verified adverse sorting in MA, implying that benefit generosity is vulnerable to under-provisioning.

Finally, the third chapter investigates the effects of risk adjustment on welfare. The results of counterfactual analyses show that the effects of risk adjustment on consumer welfare can be underestimated under a fixed contract where the benefit designs of insurance plans are exogenous. Furthermore, I show that even with an increase in benefit generosity under a flexible contract, risk adjustment can decrease consumer surplus because of an increase in premiums and a decrease in the diversity of MA plans. However, these unintended effects of risk adjustment can be mitigated in competitive markets that include a large number of insurers. Finally, I show that risk adjustment decreases overpayments arising from risk selection and thus the total spending on Medicare.