NR 552 Week 6 Market Failure Case Study Example

Market Failure Case Study: How Adverse Selection Emptied a University's Most Generous Health Plan in the 1990s, Traced Step by Step, and What It Means for a Hospital Offering Employees a Choice of Plans

Student Name

College of Nursing, Chamberlain University

NR 552: Economics of Healthcare Policy

Instructor Name

Month Day, Year

Market Failure Case Study: How Adverse Selection Emptied a University's Most Generous Health Plan in the 1990s, Traced Step by Step, and What It Means for a Hospital Offering Employees a Choice of Plans

The Case

In the mid-1990s, Harvard University offered its employees a choice of health plans, including a generous preferred provider organization (PPO) and several health maintenance organizations (HMOs). Cutler and Reber (1998) studied what happened when the university changed how it paid for these plans. Before the change, the university's contribution was roughly proportional to each plan's premium, so employees who chose the more expensive PPO paid only part of the extra cost. Beginning in 1995, the university moved to a fixed contribution, the same dollar amount whichever plan an employee chose. Employees choosing the PPO now paid the full difference in premium out of their own pay.

The parties are the university as employer and sponsor, the employees choosing plans, and the insurers pricing each plan based on the costs of the people enrolled in it. The information that matters is each employee's own expected use of care, which employees know better than the insurer or the university, and which the premium could not reflect individually, because all employees in a plan paid the same premium.

Which Condition Fails

A competitive insurance market works well when prices can reflect the risk each buyer brings, or when buyers cannot sort themselves by risk in ways the seller cannot see. Here, premiums were uniform within a plan, and employees knew their own expected costs. That asymmetry of information is the condition that fails. Akerlof (1970) showed how such an asymmetry can unravel a market: when sellers cannot distinguish high-quality from low-quality goods, or here, insurers cannot distinguish low-risk from high-risk enrollees, prices settle at an average that drives the better risks out.

The Mechanism in Sequence

Step 1: The price difference grows. Under the fixed contribution, the employee's share of the PPO premium rose sharply relative to the HMOs. The PPO's advantage, broad choice of doctors, was now priced in full.

Step 2: The healthiest leave first. Employees who expected to use little care gained little from the PPO's broader network and now faced a much higher price, so they switched to HMOs. Those who expected to use a lot of care, often older or with chronic conditions, valued the PPO's choice most and stayed. Cutler and Reber (1998) found that the employees who left the PPO were younger and lower-cost than those who remained.

Step 3: The premium rises again. With a sicker, costlier group remaining, the PPO's average cost per enrollee rose, and so did its premium for the next year.

Step 4: The sorting runs again. The higher premium pushed out the next tier of relatively healthy enrollees, and the remaining pool became costlier still.

Step 5: The plan collapses. Within about three years, the PPO had become so expensive, and its pool so adverse, that it was withdrawn. This is the pattern economists call an adverse selection death spiral.

Who Was Harmed

The employees who most valued the PPO, those with health problems who wanted a wider choice of doctors, lost it. The healthier employees who moved to HMOs saved money, and the university's own costs fell. Cutler and Reber (1998) estimated that the change produced savings from more price competition among plans but also a loss from adverse selection, because people who would have valued the generous plan above its fair cost could no longer buy it at a price reflecting average risk. The market allocated insurance less efficiently even as costs fell.

Remedies

Three remedies address the failed condition.

Risk adjustment. The sponsor pays each plan more for sicker enrollees and less for healthier ones, so plans are not penalized for attracting high-risk members and premiums can fall back toward average. This targets the asymmetry directly.

Contribution design. A sponsor can contribute a percentage of the premium rather than a fixed amount, which reduces the price gap employees see. This reduces sorting but weakens price competition among plans.

Limiting choice or requiring enrollment periods. Restricting when employees can switch plans slows the spiral, and offering fewer plans reduces sorting, but at the cost of choice.

Arrow (2001) argued that uncertainty and information problems are pervasive in medical care and that nonmarket institutions often arise to deal with them. Each remedy above is such an institution, trading some market efficiency for stability.

Why Health Insurance Is Prone to This

Health insurance markets are especially vulnerable to adverse selection for reasons Arrow (2001) described: illness is unpredictable for any one person, but individuals often know more about their own health and likely use of care than insurers do. Premiums set for a group, rather than priced to each person, create an incentive for low-risk people to choose the cheapest adequate plan and for high-risk people to choose the most generous one. When the price difference between plans is small, as it was under Harvard's original percentage contribution, the incentive is weak. When the employee pays the full difference, the incentive becomes strong enough to drive sorting.

The same mechanism appears in individual insurance markets, supplemental plans and any setting where people choose coverage with information the seller cannot price. That is why policy designs such as risk adjustment, coverage requirements and fixed enrollment periods recur so often in health insurance: each is a response to the same failed condition.

Application to Our Hospital

Our hospital offers its 4,200 employees a choice between a broad-network plan and a narrower plan built around our own system. The benefits committee has proposed moving from a percentage contribution to a fixed-dollar contribution next year to encourage employees toward the narrow plan. The Harvard case suggests caution. If the change widens the price gap enough, healthier employees may leave the broad plan, raising its costs and premiums, and employees with chronic conditions, including many nurses managing their own diabetes or back injuries, would bear the rising price. Before adopting the change, the committee should model enrollment by expected cost, consider risk adjustment between the two plans and set enrollment rules that slow any spiral. The case shows that a pricing change aimed at efficiency can remove a plan that some employees value highly, through a mechanism no one intended.

References

Akerlof, G. A. (1970). The market for "lemons": Quality uncertainty and the market mechanism. Quarterly Journal of Economics, 84(3), 488-500. https://doi.org/10.2307/1879431

Arrow, K. J. (2001). Uncertainty and the welfare economics of medical care. Journal of Health Politics, Policy and Law, 26(5), 851-883. https://doi.org/10.1215/03616878-26-5-851

Cutler, D. M., & Reber, S. J. (1998). Paying for health insurance: The trade-off between competition and adverse selection. Quarterly Journal of Economics, 113(2), 433-466. https://doi.org/10.1162/003355398555649