Flexible Spending Accounts and Adverse Selection

I model the interaction of flexible spending accounts (FSAs) and conventional insurance in a simple discrete loss setting with asymmetric information. I show that FSA availability can break a separating equilibrium, even when one would otherwise exist, because high-risk types might prefer the lower-coverage contract supplemented with FSA funds. In this case there may exist a Pareto-inferior separating equilibrium. It is also shown that FSA availability alters the optimal pooling contract. Employers can reduce coverage levels, raising expected utility for low-risk types, and can compensate high-risk types by offering supplemental FSA coverage. Thus, it is possible that FSAs strengthen pooling contracts. Copyright (c) The Journal of Risk and Insurance, 2010.