Sophistication and Insurance: Asymmetric Information, the Ability to Game the System, and Prescription Drug Insurance

Abstract:     
In complex insurance contracts, individuals can use sophisticated strategies to avoid out-of-pocket expenses. Sophistication and expected claims are affected by similar factors, creating a systematic positive or negative correlation between them. Depending on this correlation, sophistication can lead to advantageous or adverse selection, and selection may differ between the intensive and extensive margin. Responding to sophistication, insurers may distort contracts by making them excessively simple or complex, to reduce or magnify enrollees' ability to game the system. I show two sophisticated prescription drug-related behaviors each reduce out-of-pocket prescription drug costs by half and are strongly associated with expected claims.

Keywords: insurance, sophistication, asymmetric information, health care, prescription drugs, contract design, adverse selection, advantageous selection, household decision making

JEL Classifications: D1, D21, D82 , D83, D86, H3, I11

Working Paper Series