Adverse Selection and (un)Natural Monopoly in Insurance Markets

Adverse selection is a classic market failure known to limit or “unravel”' trade in high-quality insurance and many other economic settings. While the standard theory emphasizes quality distortions, we argue that selection has another big-picture implication: it unravels competition among differentiated firms, leading to fewer surviving competitors—and in the extreme, what we call “un-natural” monopoly. Adverse selection pushes firms toward aggressive price cutting to attract price-sensitive, low-risk consumers. This creates a wedge between average and marginal costs that (like fixed costs in standard models) limits how may firms can profitably survive. We demonstrate this insight in a simple model of insurer entry and price competition, estimated using administrative data from Massachusetts' health insurance exchange. We find a large “selection wedge” of 20-30% of average costs, which (without corrective policies) unravels the market to monopoly. Our analysis suggests a surprising policy implication: interventions that limit price-cutting can improve welfare by supporting more entry, and ultimately lower prices.