Competition Leverage: How the Demand Side Affects Optimal Risk Adjustment

CentER Working Paper Series No. 2011-071

TILEC Discussion Paper No. 2011-039

37 Pages Posted: 20 Jun 2011 Last revised: 5 Sep 2011

See all articles by Michiel Bijlsma

Michiel Bijlsma

De Nederlandsche Bank; Tilburg Law and Economics Center (TILEC)

Jan Boone

Tilburg University - Center for Economic Research (CentER); Centre for Economic Policy Research (CEPR); TILEC

Gijsbert Zwart

University of Groningen

Multiple version iconThere are 2 versions of this paper

Date Written: July 4, 2011

Abstract

We study optimal risk adjustment in imperfectly competitive health insurance markets when high-risk consumers are less likely to switch insurer than low-risk consumers. First, we find that insurers still have an incentive to select even if risk adjustment perfectly corrects for cost differences among consumers. Consequently, the outcome is not efficient even if cost differences are fully compensated. To achieve first best, risk adjustment should overcompensate for serving high-risk agents to take into account the difference in markups among the two types. Second, the difference in switching behavior creates a trade off between efficiency and consumer welfare. Reducing the difference in risk adjustment subsidies to high and low types increases consumer welfare by leveraging competition from the elastic low-risk market to the less elastic high-risk market. Finally, mandatory pooling can increase consumer surplus even further, at the cost of efficiency.

Keywords: health insurance, risk adjustment, imperfect competition, leverage

JEL Classification: I11, I18, G22, L13

Suggested Citation

Bijlsma, Michiel and Boone, Jan and Zwart, Gijsbert, Competition Leverage: How the Demand Side Affects Optimal Risk Adjustment (July 4, 2011). CentER Working Paper Series No. 2011-071, TILEC Discussion Paper No. 2011-039, Available at SSRN: https://ssrn.com/abstract=1868303 or http://dx.doi.org/10.2139/ssrn.1868303

Michiel Bijlsma

De Nederlandsche Bank ( email )

Netherlands

Tilburg Law and Economics Center (TILEC)

Warandelaan 2
Tilburg, 5000 LE
Netherlands

Jan Boone (Contact Author)

Tilburg University - Center for Economic Research (CentER) ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 466 2399 (Phone)
+31 13 466 3042 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

TILEC ( email )

Warandelaan 2
Tilburg, 5000 LE
Netherlands

Gijsbert Zwart

University of Groningen ( email )

P.O. Box 800
9700 AH Groningen, Groningen 9700 AV
Netherlands

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