Population ageing, taxation, pensions and health costs, CHERE Working Paper 2007/10



which is known to be notoriously badly handled by private annuity markets due to
adverse selection, and which cannot be dealt with simply by increasing total saving.
Individual insurance buyers are much better informed about factors such as their
state of health, previous and current life style, and family health history that
determine their risk class in terms of whether they have a high or low probability of
a relatively short life. The private market solution to the adverse selection problem
involves restricted coverage to good risks, which represents the market failure. It
can be shown that an insurance system that pools all risks by giving everyone the
same coverage and the same rate of return, in such a way that the scheme breaks
even actuarially, involves no market failure, but does represent a redistribution of
income from good to bad risks. For this reason it cannot be sustained as equilibrium
on a private annuities market: sellers could always find profitable contracts that
would bid good risks away from the pooled contract. However, a publicly operated
pension system does not allow such separation of risk types - it enforces pooling.
33

Similar arguments apply to health insurance markets, defined broadly to include not
only those that provide coverage for health care costs, but also those that insure
against loss of income and income-earning possibilities due to ill health and
invalidity. Again adverse selection problems arise in such markets. There are also
serious problems of market failure due to asymmetric information that arise out of
moral hazard on health insurance markets.
34 Such problems arise in both public and
private health insurance systems, but there appears to be no evidence to suggest that
privatization of public systems actually reduces the welfare losses due to these
problems, and there are a number of areas in which they could be expected to get
worse.

7 Conclusions

This paper has argued against the policy position that begins with a doomsday
scenario of publicly provided health insurance and pension systems threatened with

33 Rees and Apps (2006) show that this is a better outcome than the market outcome, and would be
preferred by any policy maker who is (at least weakly) averse to inequality in levels of welfare among
individuals.

34 For a general discussion, see Newhouse (1992).

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