Information Frictions and the Welfare Consequences of Adverse Selection

November 2015
Benjamin R. Handel, Jonathan T. Kolstad, Johannes Spinnewijn

We develop a simple model of information frictions—beliefs about plan options that affect consumer choices but not underlying utility—and adverse selection in insurance markets. We demonstrate the important impact information frictions have on equilibrium outcomes as well as welfare. We decompose these impacts into level and sorting effects; changing information frictions (or enhancing consumer information) can impact both the level of demand for a particular consumer but also has the effect of re-ordered consumers along the demand as well as the average cost curve. We also examine the complementary nature of demand side policies (information provision) and supply-side policies (insurer-level risk adjustment). We study the key predictions of the model using proprietary data on insurance choices, utilization, and consumer information from a large firm. We leverage estimates from prior work with these data, where large information frictions exist, to show that such frictions have important implications for equilibrium outcomes and adverse selection. In a counterfactual that eliminates these fritctions, the share of the market choosing generous coverage falls from 84% to 21% and reduces average per consumer welfare by $47. We then find that insurer risk-adjustment transfers, a supplyside policy aimed at reducing adverse selection, enhances welfare in adversely selected markets and removes 38% of the welfare loss from selection when frictions are removed. We show that these risk-adjustments transfers are more important for welfare as consumers are more and more informed.

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