Optimal Categorization

Posted on behalf of Ronen Avraham as part of the Legal Discontinuities Online Symposium.

Fennel’s excellent paper deals with the problem of “optimal categorization”. Using one of her examples- insurance and the problem of adverse selection- the question is whether in order to combat adverse selection insurers should “split” – divide the pool into more homogeneous and smaller risk pools, or “lump”- sell insurance on a group-based basis.

There are two features that create the problem of adverse selection: the asymmetric information between the insurers and insureds and the strategic behavior by insureds (selecting in and out of the pool). These are, as we have learned from Ronald Coase, two types of transaction cost. Put differently, categorization (splitting or lumping) is a solution to the general problem of transaction costs.

Indeed, understanding the type of costs involved in the underlying problem can better help with designing solutions.  For example, if asymmetric information is a necessary condition for adverse selection to emerge, then disclosure and underwriting might be the necessary solutions- they bridge the asymmetry of information. Indeed, insurance companies and insurance law make lots of effort to bridge the information gap between the parties. Insurers are allowed to ask questions which infringe on our privacy in order to better understand the risk insured. Later they are allowed to even deny coverage from those insureds who have misrepresented their risk, in order to deter applicants from hiding important information about the risk insured in the first place. If there are cheap ways to close the informational gap (such as imposing duties to disclose information to insurers) then going granular, i.e. splitting, might be more efficient.

Here is another example for why understanding what the underlying problem is, is crucial. This time it is about the other problem that creates adverse selection- strategic behavior. If allowing insureds to choose whether to select in or out of the pool is a problem then restricting choice might be the solution. And, restriction comes in many flavors: First, we can make insurance mandatory as is done in many countries w.r.t health insurance. Or, second, we can make some basic coverage mandatory and then have another layer of coverage which is optional- with no ability to negotiate the terms of coverage on the one hand (less choice), but with some limited opportunity for bridging the information gap on the other, such as allowing insurers to ask about one’s age, smoking behavior and such. This is also done in many countries w.r.t, again, health insurance. Or, third, we can allow for the terms of an even higher layer of coverage to be totally free for negotiation between the parties, but with unlimited underwriting, as is done in many countries w.r.t to private health insurance. The result is that we get health insurance coverage, which is lumpy and mandatory at the bottom and granular and free at the top.

So we get a seesaw between accounting for asymmetric information and accounting for strategic behavior: If there is a cheap way to restrict strategic behavior then we no longer need to worry about the informational gap between the parties: Once everyone is required to purchase insurance, we no longer worry about adverse selection and therefore need not have individual underwriting.  And vice versa- if we don’t want to paternalistically require people to purchase insurance, then we must allow for underwriting.

Obamacare was based on this understanding of the seesaw, adopting a law where some underwriting is allowed (for example for those who smoke) with a soft requirement to purchase insurance (penalty/tax for those who don’t). The SCOTUS understood it and upheld it. The trump administration did not get it. It was able about a year and a half ago to sneak in legislation which abolished the soft requirement to purchase insurance and now it needs to deal with millions of American, worrying about losing their health insurance due to underwriting.

Go read Fennel’s paper.