Asymmetric Information in Insurance Markets: Adverse Selection and Market Failure

Social Insurance Arises, In Part, Because of Asymmetric Information • Assume there are 2 groups, each with 100 people. The first group has 5% chance of getting injured, and the second group has a 0.5% chance. • The payout is $30,000 when injured. • Table 2 shows how information affects the insurance market in this context. • It illustrates the principle of adverse selection in the presence of asymmetric information. • The insured individuals know more about their risk level than does the insurer.

Table 2 With full information, the insurance company can tell the high risks from the low risks. It therefore charges separate prices to each group; competition forces it to charge an actuarially fair price. The insurance company collects $1500 x 100 from the accident prone, and $150 x 100 from the careful. Total premiums of $165,000 equal expected costs. The premium to the accident prone is therefore 5% x $30,000. For the careful, it is 0.5% x $30,000. Now imagine the insurance company cannot tell people apart. This is a case with asymmetric information. It could continue to charge separate premiums to the different groups, taking the person’s word that they are either careful or accident prone. The insurance company collects $150 x 100 from the accident prone, and $150 x 100 from the careful. Total premiums of $30,000 are $135,000 less than expected costs. In this case, the company loses money, so it will not offer insurance. Thus, the market fails; individuals will not be able to obtain the optimal amount of insurance. The accident prone have no incentive to tell the company, however; they pay 10 times as much if they reveal truthfully about their status. The average cost for the population as a whole would be $165,000 in claims divided by 200 people, or $825 per person. Again, the company loses money, so it will not offer insurance. Thus, the market fails again with a pooling equilibrium. Another potential alternative is that the insurance company understands it cannot tell consumers apart. Thus, it charges a uniform premium for all customers. With this price structure, none of the careful people buy the policy. The company collects $825 x 100 people, but pays $1,500 x 100 people in benefits.

Does Asymmetric Information Necessarily Lead to Market Failure? • Will adverse selection always lead to market failure? Not if: • Most individuals are fairly risk averse, such that they will buy an actuarially unfair policy. • When risk averse people purchase insurance that is not actuarially fair, we say that the policy entails a risk premium: the amount that risk-averse individuals will pay for insurance above and beyond the actuarially fair price. • This leads to a pooling equilibrium, which is a market equilibrium in which all types buy full insurance even though it is not fairly priced to all individuals.

Does Asymmetric Information Necessarily Lead to Market Failure? Separating Equilibrium… • In addition, the insurance company might offer separate products at separate prices that, in some cases, would cause consumers to reveal their true types (careless or careful). • This leads to a separating equilibrium, which is a market equilibrium in which different types buy different kinds of insurance products. • The separating equilibrium still represents a market failure. • Insurers can force the low risks to make a choice between full insurance at a high price, or partial insurance at a lower price. • Although insurance is offered to both groups in this case, the low risk group does not get full insurance, which is suboptimal.

How Does The Government Address Adverse Selection? • The government can help correct this kind of market failure. It could: • Impose an individual mandate that everyone buy insurance at $825 per policy from the private company, forcing all to pool their risks. • It could offer the insurance directly, which would have similar effects. • Both policies would lead to low-risk types subsidizing the high-risk types.

OTHER REASONS FOR GOVERNMENT INTERVENTION IN INSURANCE MARKETS • Although adverse selection is an important motivation for government intervention in insurance markets, there are also motivations related to: • Externalities (early, preventive health coverage). • Administrative costs (economies of scale). • Redistribution (fairness – is it right to charge people differently because of accidents at birth?) • Paternalism (society deems that people should behave in particular ways). • “Samaritan’s Dilemma”

Institutional Features of Unemployment Insurance • Unemployment Insurance (UI) is a federally mandated, state-run program. Payroll taxes are used to pay benefits to workers laid off by companies for economic reasons. • This payroll tax averages 2.5%. • Although UI is federally-mandated, each state sets its own parameters on the program. • This creates a great deal of variation across states, which many economists use as a “laboratory” for empirical work. • UI is partially experience-rated. • The tax that finances the UI program rises as firms have more layoffs, but not on a one-for-one basis.

Institutional Features of Unemployment Insurance • There are eligibility requirements for UI: • First, individuals must have earned a minimum annual amount. • Second, the unemployment spell must be a result of a layoff, rather than from quitting or getting fired. • Third, the individual must be actively seeking work and willing to accept a job comparable to the one lost. • These eligibility requirements mean that not all of the unemployed collect benefits (44% of unemployed collect). • Even among eligibles, participation is not full. • Roughly 66% of eligibles take up the UI benefit. Non-participation (among eligibles) results from lack of information about eligibility, stigma from collecting a government handout, or from transaction costs.

Figure 1 The unemployment benefit schedule in Michigan Benefits in Michigan initially rise, and are then capped at a maximum.

Institutional Features of Unemployment Insurance • The replacement rate is the amount of previous earnings that is replaced by the UI system. • Replacement rates vary from 35% to 55% of earnings, and UI is treated as taxable income. • In addition to benefits, the duration of UI can vary. In general, an individual can collect UI for 26 weeks. This varies: • For those with sporadic work, for a state that has a “supplemental” UI program, or if there is a federal extension, as in 2003. • The time pattern of benefits must balance the trade-off between three considerations: • Consumption smoothing implies rising benefits • Work disincentives from moral hazard • Targeting

Figure 2 Net Replacement Rates Over a Five-Year Period For a One-Earner Couple With Two Children 100 Sweden 80 Other countries tend to have higher replacement rates than the U.S. 60 Belgium Net replacement rate (%) Spain 40 Especially for extended spells of unemployment. Hungary 20 USA 0 4 8 12 16 20 24 28 32 36 40 44 48 52 56 60 Length of Unemployment (months)

Institutional Features of Disability Insurance • Disability Insurance (DI) is a federal program in which a portion of the Social Security payroll tax is used to pay benefits to workers who have suffered a medical impairment that leaves them unable to work. • Current expenditures are roughly $71 billion per year. • Benefits are federally uniform, but the initial decision on qualification is made at the state level.

Institutional Features of Disability Insurance • Unlike many other programs, there is a waiting period of 5 months before an individual can collect DI. • The initial acceptance rate for DI is roughly 33%; after appeals to higher levels, the acceptance rate is roughly 50%. • The benefits equal the primary insurance amount from Social Security, computed as if the applicant were age 65. • The applicant qualifies for Medicare after two years on DI. • Detecting “true” disability is challenging. • Parsons (1991) reported on a study in which a set of disability claims was initially reviewed by a state panel, and then one year later resubmitted as anonymous new claims. • 22% of those who had initially qualified were rejected, and 22% of those initially rejected were qualified!

Institutional Features of Workers’ Compensation • Workers’ Compensation (WC) is state-mandated insurance, which firms generally buy from private insurers, that pays for medical costs and lost wages associated with an on-the-job injury. • The cash payment from WC is designed to replace two-thirds of workers’ wages. Unlike UI, these payments are untaxed, leading to a considerably higher replacement that can approach 90%. • As with UI, there is substantial state variation in the program parameters. • Unlike UI, however, the insurance premiums are more tightly experience rated.

WC across states for permanent and temporary injuries in 2003 Table 1 Yet there are dramatic differences in generosity across states. Workers’ compensation payments are larger for permanent injuries.

Institutional Features of Workers’ Compensation • A key feature of WC is that it provides no-fault insurance. • No-fault insurance–when there is a qualifying injury, the WC benefits paid out by the insurer regardless of whether the injury was the worker’s or the firm’s fault. • In the early 20th century, workers could sue their employers, but the system was viewed as unfair because low-income workers may not have had the resources to bring suit against firms.

CONSUMPTION-SMOOTHING BENEFITS OF SOCIAL INSURANCE PROGRAMS • More generous UI crowds-out other sources of income support: • Households save less • Spouses are less likely to work • Recent empirical work finds for UI that: • It mitigates the negative effects on consumption from unemployment. • Every $1 of UI reduces the drop in consumption by 30¢. • There is no parallel evidence on consumption smoothing for Disability Insurance or Workers’ Compensation, however. • DI and WC probably play a stronger consumption smoothing role than UI: disability is usually unexpected and permanent, so individuals are less able to use their own savings to smooth consumption.

Figure 3 Moral hazard in UI: are unemployment exits slower when UI benefits are higher? 0.165 But towards the end of benefits eligibility, the hazard rate spikes upward. Exit Rate from Unemployment The exits from unemployment are fairly steady for most of the benefits period. 0.100 0.050 0.035 1 5 10 15 20 26 Weeks Out of Work

Moral Hazard Effects of Unemployment Insurance • In the 26th week of unemployment, precisely the time when benefits run out, the exit rate from unemployment jumps up. • Empirical work suggests a benefit elasticity of +0.8–each 10% rise in unemployment benefits leads to an 8% rise in unemployment durations. • Is this moral hazard good or bad? • If the unemployed individual is simply using the benefits to subsidize leisure consumption (e.g., watching television, etc.), then the increase in duration is inefficient. • If the individual finds a better job match, society as a whole may gain. Job match quality is the marginal product associated with the match of a particular worker with a particular job. • There is little evidence (using wages) that UI improves match quality.

Moral Hazard in Disability Insurance • Moral hazard in DI is thought to manifest itself in higher DI application rates and lower labor supply. • If an applicant was “truly disabled,” then use of the DI program and work behavior should be unaffected by the benefit levels. • International evidence (where there is cross-sectional and over-time variation in DI generosity) suggests the implied elasticity of labor supply with respect to DI benefits is -0.3. • In the U.S., applications for DI rise during recessions, even though it is unlikely that true disability changes. Applicants find it a less costly “gamble” to go through the process when their labor market opportunities are smaller.

Moral Hazard in Workers’ Compensation • Moral hazard in WC is thought to manifest itself in reported injuries, injury durations, and types of injuries reported. • Krueger (1990) finds that for every 10% in benefits generosity, the rate of reported injury rises by 7%. • He finds that for every 10% in benefits generosity, the duration of injury rises by 17%. • Moral hazard will be worse for injuries that are hard to observe or verify, such as sprains or strains, and less of a problem for other types, such as lacerations or broken or missing limbs. He found larger elasticities for difficult-to-verify injuries. • Finally, there appears to be a “Monday effect” to WC claims. • By examining claims by day of the week, there is a large rise in sprains and strains relative to lacerations on Mondays. • This suggests some weekend injuries unrelated to the job are being passed on to the employer.

Figure 7 Partial experience rating in UI When the schedule is below the 45 degree line, firms pay less than employees get out. When the schedule is above the 45 degree line, firms pay more than employees get out. 5.4 10% means that UI benefits equal 10% of a firm’s payroll over the past 4 years The benefit ratio is total UI benefits divided by payroll. The payroll tax is at first very steep, then flattens out completely. The 45 degree line would be a fully experience-rated schedule.

The Effects of Partial Experience Rating in UI on Layoffs • Relative to a full system of experience rating, partial experience rating subsidizes firms with high layoff rates. • How is this a “subsidy”? • Firms and workers may make a joint decision whether to place the worker on temporary layoff, with a promise of being hired back later. • UI system acts to make such behavior a partially paid vacation. • With partial experience rating, the cost to the firm of doing this is less than the benefits to the workers.

The “Benefits” of Partial Experience Rating • Why is partial experience rating so common in UI programs if it leads to more layoffs? The benefit that offset this moral hazard cost is consumption smoothing. • Fully experience rated UI would “hit firms while they are down.” Yet, by having a partially experience rated system, it sustains inefficient firms that perhaps should be driven out of business. • Empirical studies have examined state systems with different degrees of experience rating. • They find that partial experience rating increases the rate of temporary layoffs. • Partial experience rating alone can account for as much as one-third of all temporary layoffs in the U.S.

Workers’ Compensation and Firms • Similar issues arise in WC. If the system is not fully experience rated, firms and workers can get together to increase “injuries” and thus the payouts from insurance. • Moreover, firms have less incentive to invest in safety, because the insurance is no-fault. • Krueger (1991) examined injury durations at firms that self-insure and at firms that buy insurance in the partially experience rated market. • By definition, self-insurance is full experience rating. The injury durations were shorter at these firms, and less sensitive to benefit increases.

TAX-BENEFITS LINKAGES AND THE FINANCING OF SOCIAL INSURANCE PROGRAMS • Tax-benefit linkages are direct ties between taxes paid and benefits received. • Summers (1989) shows that such linkages can affect the equity and efficiency of a tax. The link between payroll taxes and social insurance benefits can lead the incidence to fall more fully on workers than might be presumed. • The key point of Summers’ analysis is that with taxes alone, only the labor demand curve shifts, but with tax-benefit linkages, the labor supply curve shifts as well. • That is, workers are willing to work the same amount of hours at a lower wage, because they get some other benefit as well, such as workers’ compensation or health insurance.

Figure 10 Tax-Benefit Linkages Wage (W) Wage (W) C Creating smaller DWL. S1 S1 Mandated benefits also shift the supply curve. E S2 W1 W1 A A F B W2 W2 B W3 D D1 D1 D2 D2 Labor (L) Labor (L) L2 L1 L2 L3 L1 Wages adjust by more with the tax-benefit linkage, employment falls by less, and deadweight loss is smaller than with a pure tax.

Tax-benefits linkages and the financing of social insurance programs: The model • With full valuation, the cost of the program is fully shifted onto workers in the form of lower wages, and there is no deadweight loss or employment reduction. • This raises some issues with tax-benefit linkages, especially with respect to employer mandates. • If there is no inefficiency, why doesn’t the employer simply provide the benefit without government intervention? • Market failures, such as adverse selection, may be present. The employer that provides a benefit such as workers’ compensation or health insurance may end up with high risks. • When are there tax-benefit linkages? • They are strongest when the taxes paid are linked directly to a specific benefit that workers can receive.

Asymmetric Information in Insurance Markets: Adverse Selection and Market Failure