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IAI Actuarial Core Principles · Business Economics · Government intervention in a market

In a market for private health insurance, buyers know their own health risk better than the insurer does. Premiums are set on the average risk of the pool. Which sequence best describes the likely market failure and a rationale for government intervention?

This is adverse selection from asymmetric information. Average-risk pricing drives low-risk buyers out, raising premiums and risking market collapse, so governments may make participation compulsory or regulate pooling to keep the risk pool broad and cover affordable.

  1. AMoral hazard before purchase leads insurers to overprovide cover, so a subsidy on premiums is cut
  2. BAdverse selection: low-risk people drop out, premiums rise, and the market may unravel, supporting mandatory participation or risk-pooling rulesCorrect
  3. CPositive externalities cause overpricing, so a tax on insurers is needed
  4. DMonopoly pricing causes high premiums, so a price floor is needed
  5. Public goods characteristics cause free-riding, so insurers should be banned

Explanation

Asymmetric information before contracting is adverse selection. Pricing on average risk makes cover poor value for low-risk people, who leave, pushing the average risk and premium up. Compulsory membership or community rating counters this. Moral hazard concerns behaviour after cover, not selection.

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