Health Insurance and Market Failure since Arrow

Illness is usually unexpected and often costly. Health insurance is a contingent claims contract that moves funds from the usual state of the world, when one is healthy, to the unexpected and costly state, when one is ill. In this sense, it is a market success: an institutional response to a natural feature of the demand for health care. Without such an institution, there would be no market to transfer funds between health states. In its operation, however, health insurance introduces its own set of market failures. The key features of the health insurance institutions we observe now are, in turn, responses to the existence of these market failures. This recursive relationship between institutions and market failure is a core organizing theme of Arrow's article.

Arrow described institutional arrangements in health care as responses to the market failures of his time. Strikingly, to a reader in 2001, Arrow gave health insurance relatively little airplay in his article. Instead, Arrow devoted the bulk of his essay to the training and organization of professionals and the nature of hospitals. Today, most writers would view the topics Arrow stressed as largely secondary in importance to the organization and nature of health insurance in explaining the functioning of the health care system as a whole. Health insurance, a source of market failure on its own, has now become a central force in addressing the other market failures Arrow identified throughout the health care market.

The purpose of this article is to build on Arrow's work in examining the evolution of insurance institutions in response to the market failures that arise in individual insurance contracts and in the market for health insurance. This institutional evolution, in turn, explains why health insurance moved from the periphery to the core of the health care sector. Finally, this evolution also illuminates where private market institutions can, and where they cannot, effectively address insurance market failures.

Arrow on Insurance

Arrow addressed two aspects of health insurance in his 1963 article (and in his 1965 response to comments on it): the form of insurance contracts and the functioning of the insurance market.

With respect to the form of insurance, he noted that the scope of insurance coverage was limited. Insurance arises to cover unexpected events, so health insurance sensibly did not typically cover services that were predictable, such as maternity care. Arrow also pointed out that there was little insurance available for illness-related disabilities. He explained these limitations of insurance contracts as a market response to moral hazard, which leads to expanded utilization in the presence of insurance. Arrow described the coexistence of three types of insurance: cash indemnity policies, cost indemnity policies, and prepayment plans. In his view, none of these existing insurance contracts fully addressed the problem of moral hazard. He suggested that insurance contracts generally lacked much incentive for patients or providers to seek, or provide, low-cost services. Thus, expansions of health insurance drove up expenditures on health care.

Arrow emphasized two features of insurance market functioning. First, he noted the role of large groups in the insurance market. He viewed the existence of these groups as an institutional response to administrative economies in the selling of insurance, pointing out the difference in costs between individual and group coverage. Arrow attributed gaps in coverage largely to the difficulty that certain groups had in taking advantage of administrative economies in the purchase of coverage. Groups that did not have direct access to employer-sponsored insurance lacked individual coverage, he implied, because they faced very high loading costs associated with the difficulty of selling individual policies.

Second, he considered the role of the relatively noncompetitive, Blue Cross-dominated insurance market of his day. That market pooled unequal risks--providing insurance that directly contradicted the economic theory of insurance markets. He argued that Blue Cross was an institutional response to the lack of long-term health...