The Welfare Effects of Adverse Selection in Privatized Medicare

This paper estimates the welfare losses from market failures caused by adverse selection in privatized Medicare. I model insurers' premium and coverage choices in an environment where consumers have heterogeneous preferences and may impose different costs on their insurers. The model generates predictions about insurers' costs and behavior under varying degrees of adverse selection. I use the model and exogenous variation in market structure to identify a causal link between consumers' types and insurers costs. From the estimated parameters, I can infer whether consumers' preferences, which determine how much insurance they purchase, contain information about their expected health. The empirical results imply that adverse selection is indeed present in privatized Medicare. It is more costly to insure consumers with strong preferences for health insurance. With the estimated model, I simulate new equilibria after removing the distortionary effects of adverse selection from insurers' costs and incentives. The new equilibria exhibit more generous insurance coverage and lower premiums. These effects are particularly strong in markets with many insurers. The total surplus associated with privatized Medicare increases by 15.1%, suggesting that the welfare losses from adverse selection are substantial.