Adverse Selection and Switching Costs in Health Insurance Markets: When Nudging Hurts


February 12, 2010


Ben Handel


Northwestern, Dept of Economics


This paper investigates consumer switching costs in the context of health insurance markets, where adverse selection is a potential concern. Switching costs contribute to poor choices when the market environment changes and consumers do not adjust appropriately. Though previous work has studied the problems of adverse selection and consumer choice inadequacy in isolation, these phenomena interact in a way that directly impacts market outcomes. We use a unique proprietary panel data set with the health plan choices and medical utilization of employees at a large firm to show that (i) switching costs are large and (ii) switching costs significantly impact the degree of adverse selection in equilibrium. We estimate a structural choice model to jointly quantify switching costs, risk preferences, and health risk in the population. We use the output of this model to study the welfare impact of an information provision policy that nudges consumers toward better decisions by reducing switching costs. In a partial equilibrium setting where observed plan prices are held fixed, we find that a policy that completely eliminates switching costs improves consumer welfare by 10%. In a general equilibrium setting where insurers change prices to reflect the expenses of their risk pools, the same policy (i) exacerbates adverse selection (ii) reduces consumer welfare by 6% and (iii) has distributional implications that favor those who switch as a result of the intervention relative to those who do not.


Ben Handel

Ben Handel grew up in Rhode Island, got his AB in economics with concentrations in applied mathematics and finance from Princeton in 2004. At Northwestern he’s a Ph.D. Candidate in economics studying industrial organization with a focus on health care markets. He’s done short work stints in the area of economic consulting, energy policy consulting, and in the consumer credit industry.