Government Intervention in Insurance Markets

Gruber 12.7: Mandates vs. Direct Public Provision

Why does the government mandate individuals to purchase their own insurance in some cases—such as automobile liability insurance—but directly provide insurance to people in other situations—such as health insurance?

According to Gruber, there are five primary reasons why the government intervenes in the insurance market:

• Adverse selection
• Externalities
• Administrative costs
• Redistribution
• Paternalism

Adverse Selection and Market Stability

Adverse selection occurs when insured individuals know more about their risk level than the insurer does. This asymmetry might cause those most likely to experience an adverse outcome to select insurance, leading the insurer to lose money if they offer coverage. Both mandates and direct public provision can effectively resolve the adverse selection problem.

Externalities and Paternalism

In health care, the critical externality in most systems is the care provided to others. You benefit from a positive externality when others are healthy because it reduces the likelihood of you catching their illness. Furthermore, others choosing to purchase health care also affects your health care costs. Generally, the healthy pay more to the insurance company than they receive in treatment, while the opposite is true for the sick.

Paternalism occurs when the government is concerned that individuals may be harming themselves by not purchasing insurance. Either type of intervention—mandates or direct provision—can address these specific market failures.

Redistribution of Risk

Redistribution is important because governments may want to intervene in insurance markets to group different risk types together. This ensures that low-risk and high-risk consumers pay the same premium for social insurance. The desirability of redistribution is subjective. In health insurance, high-risk individuals are often people unlucky enough to be sick, making redistribution more desirable. Conversely, in the auto insurance market, high-risk individuals are often reckless drivers, making redistribution less desirable.

Administrative Cost Efficiency

The differences in administrative costs between private provision and direct public provision represent another reason to utilize social insurance. It may be that differences in administrative costs are quite large for medical insurance (justifying direct provision) but relatively small for auto insurance (justifying mandates).