Arrow's Model of Health Insurance

Definition

Arrow's Model of Health Insurance is a theoretical framework developed by economist Kenneth Arrow that examines the complexities and market failures in the health insurance sector, primarily focusing on issues like adverse selection and moral hazard. The model highlights how information asymmetry between insurers and insured individuals can lead to adverse selection, where only high-risk individuals seek insurance, and moral hazard, where having insurance may encourage riskier behavior. This framework is crucial for understanding the dynamics of health care markets and the inefficiencies that can arise without proper regulations.

5 Must Know Facts For Your Next Test

1. Kenneth Arrow first introduced his model in a seminal paper published in 1963, which laid the groundwork for understanding health economics.
2. The model suggests that health insurance markets can fail due to adverse selection, causing high-risk individuals to dominate the insurance pool.
3. Moral hazard complicates health care costs because individuals may over-utilize services when they are shielded from the financial consequences of their decisions.
4. Arrow argued that government intervention might be necessary to correct these market failures, through regulation or public insurance options.
5. The insights from Arrow's model have influenced policy debates on health care reform and insurance design in many countries.

Review Questions

• How does Arrow's Model of Health Insurance explain the concept of adverse selection, and what implications does this have for insurers?
  • Arrow's Model explains that adverse selection occurs when individuals with a higher likelihood of requiring medical care are more inclined to purchase health insurance. This leads to an insurance pool that is skewed towards high-risk individuals, which ultimately increases costs for insurers. As a result, insurers may raise premiums or exit the market, further exacerbating the problem and leaving low-risk individuals without coverage.
• Discuss how moral hazard influences behavior among insured individuals and its impact on health care costs.
  • Moral hazard occurs when insured individuals take greater risks or over-utilize health services because they do not bear the full cost of their actions. For example, if someone has comprehensive insurance, they may be less cautious about their health choices or seek unnecessary medical treatments. This behavior can significantly increase overall health care costs, putting financial strain on insurers and leading to higher premiums for all insured individuals.
• Evaluate the potential solutions proposed by Arrow's Model to address issues of adverse selection and moral hazard in health insurance markets.
  • Arrow's Model suggests several potential solutions to tackle adverse selection and moral hazard, such as implementing mandatory insurance coverage to broaden the risk pool and lower costs. Additionally, establishing regulatory measures to promote transparency can reduce information asymmetry between insurers and consumers. Public options or subsidies might also help lower barriers to access while encouraging healthier behaviors through wellness programs and incentives for preventive care. These strategies aim to create a more equitable and efficient health care system.

Related terms

Adverse Selection: A situation in which individuals with higher risks are more likely to purchase insurance, leading to an imbalanced risk pool and higher costs for insurers.

Moral Hazard: The tendency for insured individuals to take on more risk because they do not bear the full consequences of their actions, often leading to increased claims.

Information Asymmetry: A condition where one party in a transaction has more or better information than the other, leading to imbalances in decision-making and market outcomes.