Illustrating adverse selection in health insurance markets with a classroom game.

• Author: Mellor, Jennifer M.
• Position: Targeting Teaching

1. Introduction

   Theoretical lessons about common insurance market failures can be made accessible to students through the use of case studies, legislative proposals, and other evidence from the "real world." In this paper, I describe a classroom demonstration of a health insurance market in which asymmetric information leads to adverse selection under different insurance regulatory regimes. The basic setup builds on the exercise used by Holt and Sherman (1999) to illustrate how asymmetric information about product quality can lead to adverse selection in the goods market. The first part of this game simulates a market in which low- and high-risk buyers can purchase insurance policies from sellers; in some periods, government-mandated community rating prevents sellers from using information about buyer type to determine premiums. The results demonstrate several textbook predictions regarding the effect of asymmetric information on insurance markets, namely, that it can lead low-risk buyers to drop out of the market and that it can reduce consumer welfare.

   The second part of the game adds a layer of complexity by allowing sellers and buyers to exchange two types of health insurance policies, one moderate and another generous. This feature reflects a common practice in many employer- and government-sponsored insurance programs. Like the first, this part of the game also shows how adverse selection can lead low-risk buyers to forego insurance under government-mandated community rating. In addition, a government regulation that limits premium increases demonstrates how adverse selection can lead to an inefficient sorting of buyers across plans, with none of the buyers selecting the generous plan. The results of either part of the game can be incorporated into classroom discussions of the causes and consequences of adverse selection for consumers and insurers and of solutions that employers and government payers can implement. The results from the second part of the game can be used to discuss the sequence of events leading to adverse selection "death spirals" (when generous plans are no longer offered in the market) and strategies to deter this type of adverse selection, such as retrospective risk adjustment and the use of proportional subsidies in employer-sponsored plans.

   This game can be used to illustrate adverse selection in undergraduate courses such as health economics and intermediate or advanced microeconomic theory. First-time users of the game may prefer to run each part in a separate class period, followed by discussion. With practice, you can carry out both parts of the game in one 75-minute class and hold class discussion in a subsequent period, or you may continue running the parts separately if class periods are shorter. (1) The exercises work with groups of 10 to 35 students and require only a few index cards to be prepared in advance, and copies of the instruction and record sheets, which are included in the Appendix.

2. Classroom Demonstration Procedures

   Begin by dividing the students evenly into seven different groups of roughly equal size. (2) Three groups will act as sellers of insurance, and four groups will act as buyers; it is helpful to have buyers and sellers sit in groups on separate sides of the room so that information is not shared. In the description below, I use the term "seller" to refer to a group of students acting collectively as one seller, and the term "buyer" to refer to a group acting as one buyer.

   Part 1: An Insurance Market with Two Types of Buyers and One Type of Policy

   Give each group member either a seller or buyer Part 1 instruction sheet and provide each group with a Part 1 record sheet according to their roles in the market. You can read aloud the common portions of the instructions, which are the "Introduction" and "Decisions" sections, pausing during the "Earnings" section for students to read this privately. The common portions inform the students about the basic structure of the game and the types of decisions to be made by buyers and sellers in several periods of play; the private portion contains information about seller costs and buyer values, which should not be revealed to the entire class.

   Full-Information Periods

   In the first few periods, sellers and buyers both have information about the "type" of buyer involved in the exchange. Note that buyer type is meant to correspond to risk level, but it is not necessary to make that connection to students. Similarly, the terms full and asymmetric information are used here to describe the structure of the game, but you can avoid using them during the game. Begin each period by instructing sellers to determine two premiums for an insurance policy that will be "sold" to buyers and to write these values on their record sheets. Specifically, sellers must determine a premium for a policy sold to a type 1 buyer and a premium for a policy sold to a type 2 buyer; sellers do not choose the quantity produced. In making these decisions, sellers know from the instructions that their earnings are calculated as the difference between the premium received and the cost of the policy and that sellers who do not sell a policy have earnings equal to zero. The seller instruction sheets also denote the costs of a policy sold to a type 1 buyer and a type 2 buyer. The cost of selling a policy to a type 2 buyer exceeds the cost of selling to a type 1 buyer, as shown in Table 1.

   While sellers make decisions about their premiums, you should randomly assign buyer type by having one member of each buyer group draw one of four index cards. For this, you will need to have two cards that have been marked in advance as "Type 1" and two cards marked as "Type 2." As soon as all sellers are finished determining the two premiums, collect the seller record sheets and post this information in a table for all students to see. If you use the blackboard rather than a transparency, you may also want to keep a paper record of the decisions for subsequent analysis. Table 2 illustrates one method of reporting this information; note that in each period there will be a total of six values posted on the board (two premiums from each of three sellers). Then, return the record sheets to the sellers.

   Once premiums are displayed, give buyers the opportunity to purchase a policy. Buyers know from the instructions that their earnings are calculated as the difference between the value of the policy to the buyer and the premium paid for the policy. The value of an insurance policy to a type 2 buyer exceeds the value of insurance to a type 1 buyer, as shown in Table 1. Any buyer can also elect not to purchase a policy; in this case, earnings for the buyer will equal zero. Ask each buyer, in turn, to reveal buyer type, to choose whether to purchase a policy or not, and finally, to state the seller from which the policy is purchased. Limit each seller to the sale of no more than two policies of any type or types. This will increase the number of students who can participate in the game and streamline seller calculations to fit the record sheet.

   When all buyer and seller groups have recorded their earnings from the first period, repeat the process above several times. You should shuffle and redistribute the index cards denoting buyer type at the beginning of each new period. To further increase student interest, it is helpful to begin the purchasing in each period with a different buyer; you can start with buyer 1 in period 1, buyer 2 in period 2, and so on, or you can draw cards to determine the order. After two or three additional periods, you should expect the premiums of policies sold to range from $40 to $50 for type 1 buyers, and $70 to $90 for type 2 buyers. If the market (i.e., the group of students acting as sellers) is competitive, policies will be sold at or very close to cost; that is, type 1 buyers will pay close to $40 for a policy, and type 2 buyers will pay close to $70. The results in Table 2 show that fourth period premiums were very close to the competitive level in this classroom exercise, at $41 and $70.01 for type 1 and 2 buyers, respectively.

   Asymmetric-Information Periods

   After a period in which you observe selling premiums that are at or near the competitive level, announce that a change will be made. Specifically, you can read: "The state legislature has just enacted a community rating regulation that requires insurance companies to set premiums at the same level for all buyers. Premiums set by sellers in this next period are subject to this new regulation, and no seller can refuse a sale at the posted premium in light of the buyer's type." This announcement introduces an insurance market regulation that has been adopted by many states to increase access to healthcare. By 2003, 10 states had implemented mandatory community rating of some form in the individual insurance market, and 15 states had done so in the small group market (Kaiser Family Foundation 2004). The last part of the announcement makes the change more effective by adding a restriction similar to federal law requiting "guaranteed issue" in the small group market under the Health Insurance Portability and Accountability Act (HIPAA) of 1996.

   While...