Cross product subsidization in the health insurance market with managed care: A model and issues

One theory of insurance markets suggests that entering insurers expect incumbent insurers to react to the entry of new products, offering a combination of products where, breaking even, one makes positive economic profits and the other makes a loss. This theory is extended to include moral hazard, in which the magnitude of the loss depends on insurance coverage, and a stylized model of managed care. With moral hazard, cross-subsidization is still predicted. In contrast to prior results, the coverage for the highest risk individuals will vary with the portion of high-risk individuals in the market. The inclusion of managed care as a signaling instrument does not disrupt cross-product subsidization. These theoretical predictions are discussed in light of the absence of empirical support to date and in light of other factors that might limit or enhance an insurer's ability to subsidize across products.