What is adverse selection anyway?

by on February 5, 2007 at 7:17 am in Economics | Permalink

Let me again cite Alex’s strong arguments against the importance of adverse selection in insurance markets.  Here is Paul Krugman, and here is Brad DeLong, both of whom see adverse selection as the central health care problem.

How can we square these differing points of view?

When I argue that adverse selection is not the key, I hear a common response: "*You* try getting insurance after you have been diagnosed with an advanced brain tumor," or something along those lines. 

To be sure, this is a real point but it is not adverse selection.  Adverse selection requires asymmetric information, namely that I know more about my brain tumor than does my potential insurance company.  The more likely problem is that the tumor is common knowledge, or would be if I applied for insurance, and the company won’t sell a policy for any price cheaper than the costs of treatment.  There is no asymmetry of information, rather insurance simply is no longer possible.  In the limiting case, imagine that a predictor-demon could forecast your lifetime medical expenditures with certainty, and then blog them by your social security number.  Such a person, no matter how healthy, couldn’t buy insurance either.

Scream all you want, but that is not inefficient per se (don’t complain in the comments about the limits of the efficiency concept, and the cruelness of economists, I’m already on that one, scroll down to #7 under "microeconomics", alternatively you might make a complicated Rawlsian argument.)  Covering these people, by the use of government policy, is a transfer, not an efficiency improvement, with an added caveat for imperfect capital markets.

Defenders of the adverse selection argument in reality believe the following: if someone is going to face death, or a very bad medical outcome, and can’t buy their way out of it, government should put up the money, at least within limits.

Maybe yes, maybe no, but now we are comparing competing investments and which will bring the greatest utilitarian good and the greatest moral good.  I’m far from convinced health care access wins that race or even comes in second.

And that is a general point, it is not about the United States and whether we pay more to get less compared to Europe, and so on.  Please don’t bring up that comparison to distract yourself from the logical force of this point or to think you can get a free lunch.  If you wish, think of it as whether the Netherlands should subsidize as much health care as it does. 

The point is this: defenders of the single-payer system, by invoking adverse selection, wish to claim efficiency on their side.  If the single-payer system were more efficient, we would not have to worry about competing investments, in fact we could make more of such investments by moving to a single payer.

But what looks like adverse selection is in reality something just a wee bit different.  That wee bit, however, is an important bit.  The desirability of the supposed remedy follows from an ethical judgment, not the prospect of a Pareto improvement.  And then we are back to comparing alternative investments for scarce resources.

I see the big marginal gains in lifestyle and in pharmaceuticals, not in access to health care per se.  And that is another reason why I am skeptical of the single-payer arguments.  That is without even considering the possible secondary consequences of so much government involvement.

I haven’t dealt with the Rawlsian approach, which attempts to transform the ex post disaster into a case for ex ante insurance and thus returns us to the realm of efficiency.  But if you reread the paragraph immediately above, that Rawlsian move, even if it succeeds on philosophical grounds (I am skeptical), still won’t save the case for a single-payer system.

1 ChrisM February 5, 2007 at 8:23 am

It seems to me that the only validity in the adverse selection argument is to point out that a larger insurance pool would aid in lowering health care costs. In my view, that means barring state regulations and allowing a national insurance market. Maybe 20 per cent lower costs could be gained by this action.

2 Zaoem February 5, 2007 at 8:46 am

I just don’t get this argument. The problem is that, fearing adverse selection, insurers exclude those with “pre-existing” conditions. This severely limits the exit options of health care consumers and thus the working of competitive markets in health care. In this sense, the problem of adverse selection matters a LOT: it shapes the way the health care market operates.

3 Brock February 5, 2007 at 9:08 am

It’s not “adverse selection” in the strictest, “Market for Lemons” sense, but it seems to me to be somewhat-related phenomenon. To quote Delong:

Insurance companies work like dogs to avoid selling insurance to people who are expensively sick or likely to get expensively sick. As a result, a huge amount of people’s work-time and information technology processing power are wasted on the negative-sum game of trying to pass the hot potato of paying for the care of the sick to somebody else. The more people separate themselves or are separated into smaller and smaller pools with calculably different exposures to risk, the worse this problem gets.

That’s not adverse selection, but it’s a problem. It just doesn’t have a name yet.

And surely the fact that I can buy insurance cheaper as a member of a group than as an individual means there is some real adverse selection going on, even if it isn’t at the point of a death spiral.

Also, it’s not so much that we liberals think that adverse selection is a big problem in the health care markets NOW. The employer provided system, for all its shortcomings, mostly eliminates the problem. It’s that we fear it taking hold under libertarian health care proposals such as Kling’s.

4 John Thacker February 5, 2007 at 9:54 am

Suppose company D offers the lowest rates to people particularly likely to remain healthy because its crack research and actuarial department has identified previously unappreciated ‘non-risk factors’. It makes appropriately low bids and pulls healthier-than-average people out of the risk pools of companies A, B, and C.

Ah, but in the long run, how bad a thing is that? If that means that insurance company D grows larger, and A, B, and C lose money, then that may be a bad thing for A, B, and C, but not necessarily for the insurance industry and society as a whole. You have to separate adverse selection for the entire market from competition among insurers. The healthier than average people are not unable to buy insurance, as in the real adverse selection case. Instead, they get cheaper insurance, whereas the sickier than average people get more expensive insurance.

In a situation where people “know a lot about their general state of health,” this is at least a better outcome than a regulated private insurance market that causes healthier people to not buy insurance at all. That’s the case in NY and NJ, where insurance companies essentially are not allowed to take prior conditions into account. (A single payer market is a different case that must be addressed separately.)

Also, a better understanding of risk factors and what causes disease is a useful thing, after all, and not totally wasted. Someone who better knows what causes diseases can take steps to change behavior to avoid it, or, if it is unavoidable, steps to mitigate the disease. That applies even to diseases that run in families. You may not think that the insurance company is the best party to spend that money, but I don’t think that it’s totally wasted, as people imply. (Insurance companies also spend lots of money encouraging people to get exercise and preventive care for similar reasons.)

how well they take care of themselves (diet, exercise, risky behavior of various kinds)

Of course, to the degree that how well people take care of themselves affects things and creates adverse selection, there’s room for improvement in health and reduced health care spending by individuals shouldering more of the costs themselves. And, conversely, the greater the problem would be caused by a system that bans insurance companies attempting to figure out how well people take care of themselves in order to charge them for it. The “how well they take care of themselves” does create a problem of adverse selection, but, to the degree that people can change their behavior, it also argues that the effort spent by insurance companies to determine it is not really in vain.

It also implies that a problem exists with single-payer health care as well, since people would have less incentive to take care of themselves. And therefore, of course, a single-payer health care plan would also spend lots of money to determine what risk factors exist for disease, and encouraging people to reduce them and engage in healthier behaviors. Just as insurers do. So the inefficiency exists in both cases.

5 TW February 5, 2007 at 10:02 am

One minor point is that you seem to be bootstrapping an argument about
adverse selection into an argument against single-payer. Single-payer is
far from the only remedy for adverse selection, and there are many reasons
to favor single payer that have nothing to do with adverse selection. So
apart from the validity of your point, I don’t think it carries as much
weight against single payer as you think it does. (I’m also not sure where
you get the idea that single-payer advocates in general think there’s a
“free lunch” to be had, but that’s probably another discussion.)

More importantly, as some have already noted, is that you’re drawing
a distinction between adverse selection and price discrimination (which is
reasonable as far as it goes), and then based on that seem to be jumping
to the conclusion that adverse selection either doesn’t exist or isn’t a
significant problem.

If you’re arguing the latter, your conclusion doesn’t hold up, i think, absent some evidence that (1) adverse selection (as you define it) is a rare and/or low-cost problem;
or (2) that there are Pareto efficiency gains associated with price
discrimination (as you define it) that offset any costs associated with
adverse selection. Absent that kind of evidence,,aren’t you just inserting
your best guess in lieu of someone else’s?

I think what you’re saying is just that the phenomenon we often think of
as adverse selection in health insurance (a form of market failure) is
really price discrimination, and therefore something that’s not necessarily
incompatible with economic efficiency. That might be right, in terms of
economically valid pricing strategies for health insurers; although, again,
because you’re a good economist you’ve framed your question in terms that
should be quantitatively answerable – and until that evidence is in, isn’t
it a matter of judgement – not economics – whether to draw the conclusion
you do that a single-payer scheme wouldn’t increase Pareto efficiency in
health insurance?

I have a bunch of more fundamental objections, too, but lack the time or
fluency to compose them right now. Anyway, the post makes a good &
provocative point – i just think you’re drawing much too strong conclusions
from it.

6 RC February 5, 2007 at 10:33 am

I agree with the argument about adverse selection, but it’s important to distinguish between Pareto efficiency and overall utility here. A government transfer of wealth in order to provide poor people with health care may not be a Pareto improvement, but it is still likely to be an overall utility improvement, because of the declining marginal utility of wealth.

It’s probably true that much of our current health care spending is inefficient, but that’s an indictment of the current system we have. It’s not an excuse for letting people go without access to health care.

Access to basic, non-emergency room health care means better prevention and treatment of chronic diseases, and also earlier detection and treatment of acute diseases. These things make a huge difference in one’s quality of life. The idea that there are some hypothetical ‘competing investments’ which would result in greater utilitarian or moral good seems pretty dubious, particularly since Tyler’s post makes no effort to spell out what those competing investments are.

7 Russell L. Carter February 5, 2007 at 11:07 am

“Maybe yes, maybe no, but now we are comparing competing investments and which will bring the greatest utilitarian good and the greatest moral good. I’m far from convinced health care access wins that race or even comes in second.”

And that’s the key problem here. The idea that this tradeoff is essentially a lifestyle/pharmaceutical issue is morally indefensible. I wrote a half dozen obvious and clear cut examples but deleted them when I realized that you understand them already, you just don’t give a damn.

I think John Holbo needs to do one of his trademark vivisections of this post.

As I observed previously, the essential philosophical imperative of Tyler Cowen’s health care position is to keep costs as low as possible for healthy people. That’s all it is, and there’s nothing at all noble about it.

8 Cyrus February 5, 2007 at 11:33 am

The adverse selection narrative makes no prediction about the cost of health care itself; it makes predictions about the relative costs of health care and insuring against health care expenses: to the extent that adverse selection is a problem, the cost of insuring against health care approaches the cost of paying for health care out-of-pocket for every individual.

The total cost of health care is irrelevant to whether adverse selection is taking place or not.

9 Cyrus February 5, 2007 at 11:43 am

Out of curiosity, has there been any attempt to apply Robinson-Patman to medical service providers that bill different amounts depending on who’s paying the fee? (Medicare / a preferred insurer / another insurer / an uninsured patient)

10 Cryus February 5, 2007 at 12:25 pm

Thus, for a single payer there is substantial incentive to include and encourage preventative care which is absent in the case of a many-provider solution.

Why? The single payer is under no competitive pressure to reduce its costs, or those of its patients. It’s not as though the government is going to let the single payer go bankrupt.

11 DK February 5, 2007 at 12:59 pm

There is a real problem here, but I agree with Tyler that “adverse selection” isn’t the right name for it. The problem is that most Americans now live with the assumption that someone else should protect them from Anything Significantly Bad. Whether it’s a brain tumor, an unhealthy diet, predictable flooding, or the price of gas, people expect some combination of the government, multinational corporations, or insurance companies to bail them out of the consequences of both their bad luck and their poor decisions. And this expectation exists even when people sign explict contracts to the contrary or when people decline coverage entirely!

This “adverse events” problem is the #1 reason why I am not a libertarian. As much as I might like a libertarian world, I don’t live in one, and people who are free to smoke and to build homes on barrier islands are going to cause my taxes to go up, since the government cannot reliably pre-commit iself to not paying the costs of their future mistakes.

Requiring everyone to buy catastrophe insurance strikes me as a realistic compromise.

12 RSaunders February 5, 2007 at 2:24 pm

I think this is where the central insight from Nyman about the wealth benefit of health insurance comes into play.

13 TW Andrews February 5, 2007 at 3:22 pm

Thus, for a single payer there is substantial incentive to include and encourage preventative care which is absent in the case of a many-provider solution.

–> Why? The single payer is under no competitive pressure to reduce its costs, or those of its patients. It’s not as though the government is going to let the single payer go bankrupt.

Because the single payer reaps the benefits of reduced payouts resulting from greater preventative care. Even without it reducing its costs, it has an incentive to encourage preventative care.

14 Christina February 5, 2007 at 3:38 pm

TW Andrews: In what world does the government care about reduced costs? Maybe this is privileged knowledge for those of us living in the DC metro area, but the Federal Government has a pretty simple approach to budgets: Use it or lose it.

15 richard February 5, 2007 at 5:32 pm

1) The Veterans Administration and Medicare both seem to do a good job of delivering healthcare and restraining costs. The VA actually seems good at preventive care.

2) The purpose of insurance is to share risks, which suggests winners and losers, at least ex post. With perfect underwriting, insurance makes no sense for the consumer. See Zifnab’s post.

3) Some of this seems an argument over terminology. Insurance companies must spend enormous amounts in underwriting to make sure they don’t insure those who will require overly expensive care. A single payer does not have this problem. A single payer can save these costs, making healthcare cheaper, all else being equal. Some suggest all else not being held equal will increase costs, others suggest it will decrease costs. Issues such as saving admin costs, easier job mobility if insurance is not a factor and peace of mind for many push me towards a single payer system.

16 dsquared February 5, 2007 at 6:03 pm

[In the limiting case, imagine that a predictor-demon could forecast your lifetime medical expenditures with certainty, and then blog them by your social security number. Such a person, no matter how healthy, couldn’t buy insurance either.]

Why would this person want medical insurance, since he would know with certainty what his expenditures were?

I can only think he’d want to buy insurance in case the predicted events happened “too early”, before he’d had time to build up a pot of savings to pay for them. But this is a policy that would certainly be sold, and could even be sold quite profitably over a suitably large risk pool. People always forget that the majority of the financial risk faced in an average book of health insurance business relates to the *timing* of losses, not their occurrence per se.

17 Bernard Yomtov February 5, 2007 at 9:36 pm

I see the big marginal gains in lifestyle and in pharmaceuticals, not in access to health care per se.

Isn’t part of “access to health care” access to expert advice and laboratory tests that help you decide what pharmaceuticals you should take?

18 js February 6, 2007 at 3:43 am

The problem with health care in America is thus: If you can buy 1 original copy of “Garçon à la pipe” by Picasso for $100 million dollars how many can you buy for 1 trillion dollars? If you said 100 you’re wrong! That’s because the mere act of division of money values does not create supply. Money can only convince people to do things. Thus, if 100% of qualified doctors who want to work are employed and working then spending more money is only going to drive the price up. People unfortunately see health care as a 1 dimensional money problem and ignore all the other factors involved that are specific to medical care giving. One example of a different approach might be to streamline the process for opening up medical colleges, sending more people overseas for surgery, etc.

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20 josh bivens February 7, 2007 at 11:32 am

Alex

I think this post is either a very slick head-fake or based on a big misunderstanding. you say that the folowing is not an argument about adverse selection:

“*You* try getting insurance after you have been diagnosed with an advanced brain tumor”

you’re right, it’s not. i’d argue it is an (ethical) argument for major health care reform, but, put that aside.

the relevant point is that the above argument is *nothing like* what either Krugman or DeLong describe as the adverse selection problem.

They both describe the AV problem correctly: at any given rate of offer, those least likely to purchase insurance are those who have greater (and correct and asymmetric) expectations of not becoming sick.

Consequently, efforts by insurers to improve their bottom line by raising premiums will often backfire by driving out the healthiest enrollees, and/or the resulting economic incentive is to spend resources trying to suss out the (asymmetric) information about prospective enrollees to avoid covering them.

you have identified a non-AV argument, but, it’s not the argument put forward by those (Krugman and DeLong, say) who support major reform in large part because of AV concerns.

josh bivens

21 Bill Stepp February 7, 2007 at 1:53 pm

Richard, if you think Medicare is so wonderful, check out Holman Jenkins Jr.’s op-ed in today’s Wall Street Journal.

22 Crasshopper February 7, 2007 at 3:47 pm

“Maybe yes, maybe no, but now we are comparing competing investments and which will bring the greatest utilitarian good and the greatest moral good. I’m far from convinced health care access wins that race or even comes in second.”

Here are two argument to convince you that health care is more important than other goods.

(1) We know from Kahneman & Tversky that losses relative to the status quo have a greater effect on utility than goods relative to the status quo. Thus if health coverage prevents suffering or discomfort, and social utility is judged by summing individual utilities, then social utility could be improved by taking money that would have gone to additional improvements of the status quo and putting it toward loss-preventions from the status quo.

(2) Hedonic treadmill argument: similarly, consumption goods lose their sheen as time passes and as we accumulate more stuff (additionally, appreciation is easier when your attention is focused on fewer things). Although we do take our health for granted as well, that’s not true when it fails. So again, preventing severe disutilities is more important than causing transitory positive utilities. We aren’t better as a nation for having migrated from VHS’s to DVD’s, but had we diverted that investment capital to medical solutions, people would be just as happy in the home-theater department and in much less grief in the hospital.

Think these work?

23 David Nieporent February 11, 2007 at 8:24 pm

Josh Bivens: the point is that the premise itself — “at any given rate of offer” — is the problem. There’s no reason for an insurance company to make the same offer to low and high risk applicants. That only happens when the government forces them to do so. (Either directly, by forcing so-called “community rating,” or indirectly, by banning them from, e.g. conducting tests that might reveal risk.)

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