Paying for Health Insurance: The Tradeoff between Competition and Adverse Selection

This paper uses data on health insurance choices by employees of Harvard University to examine the effect of alternative pricing rules on market equilibrium. In the mid-1990s, Harvard moved from a system of subsidizing more expensive insurance to a system of contributing an equal amount to each plan. We estimate a substantial demand response to the policy change, with a short-run elasticity of about -2. The reform also induced substantial" adverse selection. Because of this selection, the long-run demand response is three times the short-run response. Price variation induced by adverse selection is inefficient; we estimate the magnitude of the welfare loss from adverse selection at 2 percent of baseline health spending. Finally, as insurance choice was made more competitive, premiums to Harvard fell relative to premiums in the Boston area by nearly 10 percent. This savings was large enough to compensate for the inefficiency induced by adverse selection, so that reform overall was welfare enhancing.