Price Regulation, Risk Classification and Moral Hazard

In a market where consumers can observe their risk characteristics, price regulation may spur moral hazard on behalf of high-risk consumers. Several empirical studies have demonstrated a static cross-subsidization effect from low-risk to high-risk consumers in price regulated insurance markets. In a competitive market, the riskiest of the low-risk consumers enter the residual market since cross-subsidization surcharges make their premiums higher than premium ceilings. In this paper we develop a dynamic model of cross-subsidization that examines changes in risk classification of consumers, as a result of the institution of premium ceilings and subsequent potential changes in consumer behavior. The model can be applied in similar price-regulated markets to make inferences about population movements between risk-classification groups, expected increases in low-risk premiums and the time or level of the next action by the regulator.