Review of “Measuring Ex-Ante Welfare in Insurance Markets”

October, 2018

In this paper, the author points out the substantial conceptual difference between ex-ante welfare and
market surplus in the context of insurance markets and how getting the welfare measure right matters
for optimal policy. He shows that taking the ex-ante welfare perspective may lead to different
conclusions about optimal insurance prices, desirability of government mandates and the welfare cost
of adverse selection, than an analysis based on market surplus, which will not generally maximize
expected utility. Key difference between ex-ante expected utility and market surplus is that at the time
of buying insurance individuals may have learned about their realization of risk. So that their willingness
to pay for insurance differs from the ex-ante value, when they were still behind the veil of ignorance. In
the optimal insurance policy literature this essential distinction has thus far neither been carefully
addressed, nor provided with a reduced-form estimation approach that this paper delivers. Specifically,
it provides a sufficient statistic estimation procedure for a Baily/Chetty style optimal benefit condition.

As Hirshleifer (1971) showed, the observed willingness to pay for insurance will not capture the value of
insuring against learned private information. Hence, the time of observing choice becomes relevant for
welfare conclusions. If a bad risk has already realized, the market surplus is lower since this realized risk
is not included in the insurance value anymore. Hence, ex-ante more insurance would have been socially
optimal.

The main contribution of the paper is the provision of an empirically implementable estimation
approach for ex-ante expected utility. Following the framework of Einlav et al. (2010) it is shown how to
construct this ex-ante willingness to pay for insurance via sufficient statistics. Additionally needed is a
sufficient statistic for the difference in marginal utilities of income between insured and uninsured. This
can be achieved by using a measure of risk aversion and market level demand as well as cost curves.
These reduced form demand and cost curves are anyway required to estimate market surplus.

This paper not only discusses budget neutral policies, where cost of the insured are fully covered by
premiums and mandate penalties, but also non-budget neutral policies, where general tax money is
used for financing, for the government to intervene in order to expand the insurance market.

The author applies this framework to the health insurance market for low income adults in
Massachusetts with estimates from Finkelstein et al. (2017). This market was shown to fully unravel
when privately organized, as no one is willing to pay the premium needed to finance the pooled risk.
Hendren shows that it is beneficial from an ex-ante welfare perspective to provide government
subsidies or impose a mandate. He finds optimal insurance prices to be roughly 30% lower from an ex-
ante perspective than the market surplus maximizing price. Hence, increasing the fraction of the market
owning insurance substantially. Furthermore, a mandate in this market increases ex-ante expected
utility but decreases market surplus. Asked before learning their risk, individuals’ willingness to pay for
lower health insurance prices would have been positive.

Finally, he uses the marginal value of public funds to evaluate non-budget neutral subsidies and finds
that insurance subsidies can be a more efficient method of redistribution than observed willingness to
pay would suggest. His approach also allows for only partial learning of some private information so that
individuals are divided into observable subgroups and not behind a complete veil of ignorance.
This outstandig paper is without doubt suitable for the JPubE. It addresses a neglected issue of high
policy relevance. It is elegantly executed and provides the reader with strong intuition for the main
results. I expect it to be a lasting contribution to the field and the ground for further research in this
direction now that the methodological foundations have been set. However, there are a number of
issues, which are listed below, that in my opinion have to be tackled with greater care.

But first, a couple of points that I found to be remarkable in this paper:

1. He makes strong assumptions, such as that income does not substantially differ between
insured and uninsured to derive the measure for difference in marginal utilities between insured
and uninsured but afterwards nicely addresses these assumptions one-by-one to discuss its
limitations and illustrate how to relax them with suitable additional empirical estimates.

2. I do like that the intuition is first given in a stylized example and results are then generalized to
more realistic conditions. The stylized example is worked out nicely and extremely valuable for
developing intuition.

3. I appreciate that the paper not only provides the methodological foundations but directly
applies the concept to a real world market to illustrate its results in Section 5. The demand/cost
graphs in Section 2 and 5 are valuable illustrations that help the understanding of the
mechanisms at work.

Now, I do have a few minor suggestions:

1. It should be discussed more why ex-ante expected utility is the right/relevant welfare concept
for policy questions. The paper remains very vague about why one should be interested in ex-
ante expected utility. In the Introduction it is only stated that “often one wishes to include the
value of insuring against [realized risks]” but not really argued why this is the case.
a. One justification to develop more could be that ex-ante expected utility is equivalent to
ex-post utilitarian welfare and hence what a benevolent social planner typically wants to
maximize when he cares about all individuals equally. Or also to briefly catch up on the
Rawlsian veil of ignorance for determining the morality of a political issue.

2. In my understanding, it is ultimately all about redistribution between types. In Section 3.3 it is

argued that given the policymaker can observe characteristics of interest, ex-ante optimal
insurance does not need to be motivated by redistribution across different types, as one can
condition on these characteristics. However, I am wondering whether these markets would still
exist when conditioning on income groups in order not to introduce a strongly redistributional
tool. I find it hard to believe that within the poorest income group individuals could be taxed
sufficiently to finance the optimal level of insurance subsidies (especially as there is certainly
redistribution in the data, so for this subgroup budget balancedness does not hold when
evaluating a classic Baily-Chetty equation and hence adopting the estimated welfare improving
subsidy level would not be feasible). In practice, people at the lower tail of the income
distribution do not pay any income taxes at all. Whenever non-budget neutral financing is used
there is clearly redistribution from high income individuals that pay high taxes to low income
individuals who can benefit from lower insurance prices. Therefore, claiming that optimal ex-ant
 insurance does not need to be redistributional seems a bit hypocrite/constructed as it probably
would not pass a reality check.

3. In Section 5, the impact of the ex-ante welfare concept for optimal insurance price subsidies is
worked out for the specific example of low-income health insurance market in Massachusetts.
However, it lacks justification that it is relevant over a wider range of settings. For the case of
government mandates this is done nicely in Appendix G, which concludes that mandates
increase ex-ante expected utility for risk aversion parameters commonly estimated in health
insurance contexts. I suggest to provide some examples or to illustrate under which conditions
applying the ex-ante welfare concept rather than the market surplus matters for optimal
subsidies.

4. I found the abstract to be written in a rather cryptical manner that fails to convey what this
paper is all about. Only after reading the introduction I got a broad idea of the story and it
eventually only became clear with the stylized example. The abstract should be reformulated in
order to have a clearer message.

5. Given that the key contribution is introducing the empirical estimation approach for ex-ante
willingness to pay the introduction, motivating example and general model description are
rather lengthy. One has to read through 25 pages of preliminaries until the central Proposition 3
is reached. Giving some context and examples is absolutely essential but there is potential to be
more concise in doing that.