Question

In a private insurance market, there are two different kinds of people: some who are more likely to require expensive medical treatment and some who are less likely to require medical treatment and, if they do, to require less expensive treatment. One health insurance policy is offered, tailored to the average person's health care needs: the premium is equal to the average person's medical expenses (plus the insurer's expenses and normal profit).

In an effort to avoid the adverse selection death spiral, a private health insurer offers two health insurance policies: one that is intended for those who are more likely to require expensive treatment (and therefore charges a higher premium) and one that is intended for those who are less likely to require treatment (and therefore charges a lower premium).

Could this system overcome the problem created by adverse selection?

	A. Yes; it is likely that high-risk individuals will buy the more expensive policy and low-risk individuals will buy the less expensive policy.
	B. Yes; it is likely that low-risk individuals will buy the more expensive policy.
	C. No; it is likely that high-risk individuals will buy the cheaper policy.

Answer 1

Solution-

Could this system overcome the problem created by adverse selection? The correct option is C. No, it is likely that high- risk individuals will buy the cheaper policy. Reason- Even offering two different insurance policies will likely not work, because the insurer generally knows less well than the individual whether any given individual has a high or low risk of requiring treatment. As a result, everyone would want to buy the cheaper (lower-premium) policy. If the insurer is unable to tell whether some high-risk individuals are purchasing the insurance policy not intended for them, it will lose money on this policy and will have to increase the premium. This, again, is the first step in the adverse selection death spiral.