If there’s a realm where the normal economic logic sometimes does not apply, it’s health insurance. And without understanding how the rules are different, policy makers in state capitals may be on the brink of making a major error by declining to include some kinds of health insurance plans on the insurance exchanges they’ll launch in 2014.

Let’s back up for second and look at how health insurance is different from other products.

Usually when you buy a product, say a bag of apples at the grocery store, you know what you are getting and your grocer does not really care who you are. Your transaction happens efficiently at a price where your grocer believes supply meets demand. You get to inspect the fruit before paying for it and eating it. There are typically no apple shortages as prices adjust.

Her insurance company, meanwhile, will try to predict how many future medical claims she and its other patients will make. But that is a difficult science. Sell insurance to too many sick individuals, and an insurer can lose its shirt. There is a lot of guesswork and hidden information built into each transaction.

This information asymmetry between buyers and sellers causes insurance markets to malfunction. That’s part of the explanation for why we needed health care reform in the first place. More than 50 million Americans were uninsured—absent from the market.

What are some examples of how insurance markets function poorly? Insurance companies may sell products that are designed to deter sick people, say by offering free gym memberships but high cancer-drug co-pays. Or, on the other side, a man who has a family history of heart disease may be more likely to buy the most lavish plan at work during open enrollment, knowing that he may need all the coverage—willing to shoulder it, even at its punishingly high price. Economists call this “adverse selection.”

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