Market-based health insurance programs rely on robust insurer participation to function well. We develop a model of a health insurance market with adverse selection where insurer participation is endogenous.
We show that when low-cost consumers also tend to be highly price sensitive - the key feature of adverse selection - insurers often lose money at their profit-maximizing prices, even without fixed costs. Adverse selection (like fixed costs) generates strong incentives for insurers to undercut each other's prices, leading to equilibria with few surviving competitors - and in the extreme, to natural monopoly. Using data from Massachusetts' health insurance exchange, we leverage exogenous subsidy-driven variation in health plan prices to estimate high consumer price sensitivity and strong adverse selection.
Using an estimated structural model, we find price sensitivity and adverse selection strong enough to lead to only monopoly or duopoly in equilibrium, absent corrective policies. We show how corrective policies, including price floors and risk adjustment, can restore equilibria with greater insurer participation and higher consumer welfare.
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