High-risk individuals in voluntary health insurance markets: the elephant in the room?

The standard analytical framework of insurance markets by Einav and Finkelstein (EF) focuses on the problem of welfare loss for low-risk individuals. A key assumption of this framework is that demand and cost curves are tightly linked, meaning that people are willing to pay a price equal to their expected cost plus a risk premium. Using data from the German risk-adjustment system we show that the distribution of expected health care costs is extremely skewed. We show that incorporating the extreme skewness of predictable individual health care expenses in the EF framework has important welfare consequences, which are typically overlooked when using this framework for analysing the negative welfare effects of voluntary health insurance markets with asymmetric information. Rather than the welfare loss of low-risk individuals due to underinsurance, the main problem of voluntary health insurance markets is the welfare loss of high-risk individuals not getting access to health insurance and affordable health care. We discuss that among the policy approaches to reduce this problem, mandatory health insurance with mandatory cross subsidies is likely to be the most effective, which is typically not recognised when focusing primarily on the welfare loss for low-risk individuals.