David R. Henderson  

Adverse Selection on Purpose

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In a post a few weeks ago, I stated that I had coined a term in 1994 to describe the effects of a ban on pre-existing conditions clauses in health insurance: adverse selection by law.

This weekend, I was going through some old files and found the 1994 op/ed. I hadn't used that term. Instead, I had used the term "adverse selection on purpose." Here's the op/ed, printed in the St. Louis Post-Dispatch on July 29, 1994, and titled, "Gambling on Guaranteed Coverage." At the time, the Clinton health plan was starting to look dead:

Although Republicans and some Democratic allies may successfully kill some of the worst features of the Clinton health-care plan, such as price controls and employer mandates, they risk creating a program that could be as bad.

Sen. Dan Coats, an Indiana Republican, for example, regards the Federal Employees Health Benefit program as a model for health reform. But trying to implement a similar plan nationally would kill health insurance. The result: lousy health care for the sick.

The two key features of a nationwide federal-employees plan are guaranteed issue and community rating. Guaranteed issue means that anyone who wants health insurance can get it. Combine that with community rating--everyone pays the same premium regardless of health status--and the result is disastrous. Buying health insurance with community rating and guaranteed issue would be like betting on a horse race--after the race was won.

The vast majority of us who are well would each have an incentive to buy insurance with benefits like sports medicine and maternity benefits and then, if we get really sick, switch to a company that has good coverage for our new disease. Insurance would no longer be insurance; instead, it would be prepayment for medical care, with the "insurance" company acting as an intermediary, taking our payments and passing them on to doctors and hospitals.

What's wrong with that? Consider the incentives that it would create for insurers. Suppose that all enrollees pay a community-rated premium of $2,000. Every one whose health care costs less than $2,000 is profitable to the insurer and everyone whose health care costs more is unprofitable. Insurers would want to attract the former and avoid the latter. How can they do that? They know that if they have a reputation for being the best at treating cancer, they will attract people with cancer. So their incentive is to avoid hiring the best oncologists.

Remember that an insurance company can survive only if it covers its costs. With community rating requiring the same premiums for all, they cannot raise the premiums for only those on whom they expect to spend more. They have to raise them for everyone. As they do so, healthy people who don't need cancer treatment will drop out and switch to less costly plans.

For decades, health economists have worried about adverse selection that comes about when insurance companies can't distinguish between high-risk and low-risk clients so that the unhealthy drive up premiums for the healthy. But this is even worse: It is adverse selection on purpose. It is the necessary effect of combining community rating and guaranteed issue.

Moreover, most people wouldn't know how bad the benefits are until it's too late. At anyone time, the vast majority of people in this country are healthy. So, while healthy, they would be very satisfied with their health insurance. It's only when they really need it that they would realize how inadequate it is. Our system would become like Canada's.

Poll after poll reveals that 80-plus percent of Canadians like Canada's system of nationalized health insurance. That's not surprising. More than 90 percent of Canadians are healthy. Canadians don't see the problems until they need surgery or other expensive care and then find themselves on a long waiting list. Thousands of those who can't wait end up spending their life savings for treatment in the United States. [Note: I did not fact check this statement and I'm no longer sure it's true.]

Managed competition advocates such as Alain Enthoven of Stanford and Dr. Paul Ellwood of the Jackson Hole Group also point to the federal employee health program as a positive model for reform. But these advocates have always refused to spell out how health plans that attract enrollees with expensive-to-treat illnesses will be able to survive. The answer is: They won't.

There is a better way. Most of us would like health insurers not to cancel people's insurance after they get sick. We can have that provision, called guaranteed renewability, without community rating and guaranteed issue.

As in the case of life insurance, if we want guaranteed renewability, we should be able to get it--at a price. After all, we don't expect to qualify for life insurance after we find out we are dying. We must decide, relatively early in life, how much and what kinds of risk we want to bear and how much we want insurers to bear.

If we want guaranteed coverage, we have to buy when we are well and not try to play the system by holding off on buying insurance until we get sick. Why should health insurance be different from life insurance?


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COMMENTS (7 to date)
Karl Gallagher writes:

Health insurance is already not insurance. It's tax evasion, letting you spend pre-tax dollars on routine expenses as long as they're "health related."

Steve writes:

"Guaranteed renewable" refers to a policy that cannot be cancelled, but the insurance company can raise rates. That would still be harmful to someone who gets sick. What you want is "non-cancellable," which means that the insurance company cannot raise rates or cancel your policy (this is how the National Association of Insurance Commissioners defines these terms).

Steve writes:

Please allow me to qualify my last comment.

If you're in a large group plan, "guaranteed renewable" may have the same effect as "non-can" would have for an individual plan, since you will be subsidized by other healthy participants.

It's in the individual or small group market where it is important to have "non-can" instead of "guaranteed renewable."

Dan Weber writes:

My understanding with guaranteed renewal is that while your rates can go up, they can only go up on everyone in your pool. And all states have guaranteed renewal.

I don't know how big a pool is. If it's small enough, the company can just jack the rates high on everyone and offer to move the people they like into a new pool. I guess they could do this with large pools, too, if it was worth the hassle to them.

I don't have sources for any of this so take it with a grain of salt. Just what I've gathered over the past few years.

Excellent article, Bryan. You can just change some names around and it applies today.
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This paper from Health Affairs cites two textbook definitions of guaranteed renewable insurance:

Guaranteed Renewability And The Problem Of Risk
Variation In Individual Health Insurance Markets
by Vip Patel and Mark V. Pauly
http://content.healthaffairs.org/cgi/content/full/hlthaff.w2.280v1/DC1

The definitions (see link above for sources):

1. A guaranteed renewable [health insurance] policy is one by which the insurer guarantees to renew the policy to a stated age, such as age 65. The policy cannot be canceled, and renewal of the policy is at the insured’s sole discretion. Although an individual insured cannot be singled out for a rate increase, the insurer has the right to increase premium rates for the underwriting class in which the policy is placed.

2. Insurers commonly offer individual health insurance policies that provide guaranteed renewable coverage. At the end of the policy period, the insurer must renew coverage regardless of the health of the insured. While the premium can increase to reflect the expected experience for the individual rating class, the premium cannot be increased on an individual basis to reflect possible deterioration in the individual’s (or covered dependent’s) health.


David R. Henderson writes:

@Brian T. Schwartz,
Thanks. Actually, my name is David. :-)

hoads writes:

"Poll after poll reveals that 80-plus percent of Canadians like Canada's system of nationalized health insurance. That's not surprising. More than 90 percent of Canadians are healthy. Canadians don't see the problems until they need surgery or other expensive care and then find themselves on a long waiting list. Thousands of those who can't wait end up spending their life savings for treatment in the United States. [Note: I did not fact check this statement and I'm no longer sure it's true.]"

This sentence encapsulates the essence of state controlled healthcare systems and why the Democrats want it. They know that because the majority of people are healthy, providing government mandated low tech and "preventive" healthcare, the majority will be happy with their "benefits" and will support more government control by default. The minority sick will always be the pawns because their voices will be drowned out by the majority.

50% of medical care is consumed by roughly 10% of the population. The sick is where the money is and where the government intends to control medical resources. Care of basically healthy people is a drop in the bucket. So indeed, it is not until one really needs intensive medical care that recipients of government controlled healthcare find they have been sold a bill of goods.

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