Regulation of insurance with adverse selection and switching costs: Evidence from Medicare Part D

Abstract

I take advantage of the evolution of the regulatory and pricing environment in the first years of a large federal prescription drug insurance program for seniors - Medicare Part D - to empirically explore interactions among adverse selection, switching costs, and regulation. Using detailed administrative data, I document evidence of both adverse selection of beneficiaries across contracts and switching costs for beneficiaries in changing contracts within Medicare Part D. Motivated by this descriptive evidence, I formulate a model of contract choice that al- lows for both switching costs and private information about expected risk. Using this model, I show that switching costs are large and have quantitatively important implications for the sorting of individuals among contracts. How switching costs affect selection over time de- pends on the direction of changes in the contract space relative to the initial conditions. I find that in the present environment, on net, switching costs help sustain an adversely-selected equilibrium with large differences in risks between more and less generous contracts. I then simulate how switching costs could affect regulatory interventions that change the generosity of contracts. For example, I consider the tightening of the minimum standard requirement by \filling" the Part D donut hole as implemented under the Affordable Care Act. I find that absent any switching costs, this regulation would have eliminated the differences in risks across contracts; however, in the presence of the switching costs that I estimate, the effect of the policy is largely muted.