Question

In which of the following situations is adverse selection not a concern? [LO 10.2] a. A company offers employees the opportunity to purchase group health insurance. b. A company requires employees the opportunity to purchase group health insurance. c. The health insurance plan does not include dental care.

Short answer

Option B does not present an adverse selection concern.

Step-by-step solution

Define Adverse Selection

Adverse selection occurs when one party in a transaction has more information than the other, typically leading to the selection of bad risks by the less informed party. In insurance markets, this means individuals who expect higher need for medical services are more likely to purchase insurance.

Analyze Option A

Option A offers employees the choice to purchase group health insurance. This creates a situation where those anticipating higher medical expenses are more likely to opt in, potentially leading to adverse selection.

Analyze Option B

Option B requires employees to purchase group health insurance. By mandating everyone participate, the risk is spread across healthy and unhealthy individuals alike, thus mitigating the effect of adverse selection.

Analyze Option C

Option C involves a health insurance plan that does not include dental care. The exclusion of dental care does not directly address the concept of adverse selection in health insurance as it relates only to the type of coverage offered, not the selection dynamics themselves.

Determine the Situation with No Adverse Selection Concern

Adverse selection is not a concern in option B, because requiring all employees to purchase insurance ensures that both healthy and unhealthy individuals are pooled together, distributing the risk evenly.

Key concepts

Information Asymmetry

Information asymmetry occurs when one party in a transaction has more or better information than the other party. This imbalance can lead to poor decision-making and economic inefficiencies. In the context of insurance markets, insurers typically face information asymmetry because they do not fully know the health status or the risk level of the individuals they insure.

For example, individuals who know they are likely to need more healthcare services are more inclined to buy health insurance. Insurers might charge higher premiums to account for this risk, potentially leaving out healthier individuals who think the insurance is too costly for the benefits received.

• This can result in a pool of insured individuals that is riskier than expected.
• As a result, the insurance provider may end up paying out more in claims than anticipated.

This is why effective risk assessment and gathering accurate information are crucial for insurers to mitigate the impact of information asymmetry in their coverage plans.

Insurance Markets

Insurance markets are designed to protect individuals from unforeseen and significant financial losses due to specific risks, such as health issues, accidents, or property damage. In these markets, insurers offer policies that cover potential future losses in exchange for premiums paid by the insured.

A major challenge in insurance markets is balancing the premiums and the coverage so that neither the insurer nor the insured faces an undue burden.

• Adverse selection poses a significant challenge in this balance.
• If insurers cannot accurately assess risk, they may either undercharge high-risk individuals or overcharge low-risk ones.

To mitigate adverse selection, insurers often use strategies like mandating coverage for all within a group, as seen in mandatory group health insurance, which ensures a mix of healthier and riskier individuals.

Risk Pooling

Risk pooling is a fundamental concept in the insurance industry that involves aggregating multiple individuals' risks to minimize the impact of high-cost events. By having a large number of people in an insurance pool, insurers can spread the risk across many policyholders, which stabilizes premiums and makes insurance more affordable.

For instance, in a mandatory health insurance plan, all employees are required to purchase insurance, pooling both high-risk and low-risk individuals together.

• This distribution helps mitigate adverse selection because the overall risk is lowered.
• There tends to be a balance between claims and premiums.

Effective risk pooling not only benefits insurers by reducing unpredictability but also protects individuals by providing more stable and lower-cost insurance options.