Adverse Selection and (un)Natural Monopoly in Insurance Markets

Adverse selection is a classic market failure known to limit or “unravel” trade in insurance markets and many other settings. We show that even when subsidies or mandates ensure trade, adverse selection also tends to unravel competition among differentiated firms — leading to fewer surviving competitors and in the extreme, what we call “un-natural monopoly.” Like fixed costs in standard natural monopoly, adverse selection creates a wedge between marginal and average costs, as firms compete aggressively on price to attract (or “cherry-pick”) price-sensitive low-risk consumers. This wedge must be covered by sufficiently large markups, which limits how many firms can profitably survive. Unlike fixed costs, the underlying problem is a coordination failure that can be addressed via (careful) price regulation — a policy often used in practice but which existing models have difficulty motivating. We show the empirical relevance of strong adverse selection on price using subsidy-driven price variation and a structural model of competition in Massachusetts’ health insurance exchange. Our analysis suggests a new rationale for policies mitigating adverse selection: Without them, the market devolves to monopoly; with them, the market can sustain robust insurer competition.