Adverse Selection Once Again

Adverse selection is an easy story to tell but a hard story to verify.  In fact, empirical studies indicate that adverse selection is not an important (equilibrium) effect in the market for used cars, or used trucks, or of auto, life insurance or health insurance.  See my earlier post, Adverse Selection is NOT the Problem, for reasons why markets handle asymmetric information better than most economists think.

In two excellent posts (here and here), Bryan Caplan further points out that the adverse selection model does not explain current regulations.  Adverse selection, for example, implies that it's the low-risk consumers who drop out of the market so it's the low-risk consumers who need a mandate to buy insurance.  But…

When you actually look at these regs, you'll notice some peculiarities:

1. Mandatory insurance is most prominent in the auto insurance industry. But these regulations don't target low-risk drivers. Their main purpose, contrary to the adverse selection model, is to make sure high-risk drivers get insurance.

2. Even more shocking: The regulations usually go on to somehow subsidize the rates that high-risk drivers pay. This is necessary because, contrary to the adverse selection model, insurance companies are able to detect high-risk drivers, and do not want to cover them at a loss.

3. Economists usually mention adverse selection in the context of health insurance. But in the market for individual health insurance – precisely where you'd expect adverse selection problems to be most severe – governments very rarely mandate insurance coverage. Instead, they focus on mandatory employer-provided health insurance, where the adverse selection problem is likely to be milder.

4. When governments do mandate health insurance, they almost always subsidize the rates that high-risk buyers pay. This is once again necessary because, contrary to the adverse selection model, insurance companies are able to detect high-risk customers, and do not want to cover them at a loss.

Bottom line: Real-world insurance regulation has little or nothing to do with economists' "moral hazard and adverse selection" mantra. The "intellectual" bases of real-world regulation of insurance are rather populism and paternalism: Big bad insurers won't cover people unless it's profitable, and simple-minded consumers don't care enough about their own health to pay for it themselves.

See also Tyler's post on this issue which makes many similar points.


I didn't read the Caplan post, but I don't find the summary points very surprising, and I think that they don't clearly represent the issues:

1. Do anyone think that mandatory auto insurance is in place because adverse selection pushes safe drivers out of the market? The laws are because of the _Moral Hazard_ of low wealth people not insuring, because they can just declare bankruptcy if they cause a lot of damage to others in a wreck. Bring back debtors prison, and most people would insure without the mandate. We don't like that option as a society, so we prefer to require the insurance.

2. Again, I do not find this surprising. We subsidize the high risk drivers' insurance via regs. No one wants to pay for their insurance, but better for society to get some of their money into insurance pools than to charge a true-cost premium and have them go uninsured, causing society to eat the full cost when they cause accidents.

With uninsured medical care, the moral hazard is that those who are uninsured know that someone else will ultimately pay if their no-insurance choice leads to high cost medical care.

So, the idea of your post that mandates have little to do with "moral hazard and adverse selection" seems only 1/2 correct. I think that it is all about the moral hazard of people who choose to go uninsured, coupled with (1) bankruptcy protection and (2) society's unwillingness to let the uninsured go untreated at emergency rooms and hospitals.

Maybe I am missing something.

Point 1 is completely wrong, and covered well by the first two comments. Regarding point 2, in Norway and France where I have insured cars, high risk drivers pay higher premiums.

One more peculiarity of the adverse-selection argument is that when you hear it, often as not it's from someone who's just got done complaining about insurers cherry-picking the lowest risks.

I'm with you Alex. Tyler's penchant for inclusion of all the factors is great, especially when people are willing to listen, but sometimes the bottom line is really simple and needs to be honed in on, especially when the opposition isn't interested in actual understanding.

The left wants a revenue source to preserve the govt's fiscal sustainability, and they need a plausible, empathetic justification.

The government wants to do exactly what the evil insurance companies do - scare the healthy, profitable premium payers into the pool.

simple-minded consumers don't care enough about their own health to pay for it themselves.

That's the homo econimus answer. The homo sapiens sapiens answer might be different.

Much of the populace doesn't want to have to live in a society were they have to watch someone die for lack of available health-care, even when that lack is self-inflicted. Thus we oblige everyone to take the necessary steps to avoid that possibility.

The individual may decide that it's worth the risk, but being human beings, we all live with the result of his gamble if it fails - and for cases where the risk is a long agonizing death in close proximity to ourselves, that cost is pretty high. Thus, what is being weighed is the cost of "him paying for insurance" vs. the cost of "us having to watch his misery if the gamble fails".

When enough people feel the cost of the latter outweighs the cost of the former, then legislation gets passed.

1. This is analogous to the people who go the emergency room. We all want these people to pay, but there are other ways of doing it that could be explored. You don't need bankruptcy and don't even need debtor's prison. You could just ding them for future social safety net benefits.

Adverse selection is not the right term if people are using it. It may be a strawman, but there is plenty else they are not explaining. I'm a libertarian, but before that I was a citizen. And, for me, it's good enough to say "come back when you can tell me the truth, the whole truth, and nothing but the truth about your plan."

Bryan Caplan further points out that the adverse selection model does not explain current regulations.

Of course it does. If the government were only interested in getting high-risk drivers & patients insured, it would simply implement a mandate to provide insurance, not a mandate to buy insurance. It has to include the mandate to buy insurance because in the event of supply-side-only regulation it would drive insurance premiums up to the point were a significant share of consumers could not afford to pay for them. In both cases, no regulation and supply-side regulation, those consumers whose abstention is most likely to create social costs, will abstain from the market. Just because car & health insurance aren't as simple as the textbook model it doesn't mean it's something we can ignore.

His claim that insurances can detect high-risk drivers is also wrong (insurances know demographics and claim records, but the info on driving habits they need to pinpoint bad drivers eludes them), and he completely ignores that the economics of health and auto insurance are mostly driven by the rare catastrophic event -- the kind of casualty that exceeds both the consumer's lifetime premium payments and his/her lifetime income by multitudes. I sure hope this is not the level of analysis you're offering in your intro books, Alex.

I find the data you cite from "ahip" (I'm looking at its 2007 report) interesting in that it suggests that only 28% of individuals age 60-64 are denied health insurance because that is the number denied of the applications rated.

However, that is only for individuals who applied, and one would expect that those 22% age 55-59 who were denied because of preexisting conditions to not apply later. If you are denied because you have lupus or MS or diabetes, for example, at age 55, why apply at age 60 knowing you still have whatever resulted in denial? Such individuals will attempt to get a job with ERISA benefits, or seek government subsidized benefits.

Further, of those 72% age 60-64 offered policies, 25% are offered policies at higher than standard rates. So, of those who apply at age 60-64, only about half are offered the standard rate or lower, while the other half are denied or quoted higher rates. Again, if you were quoted a rate at age 55 that you couldn't afford, why would you apply at age 60 knowing the rate will almost certainly be even more unaffordable.

Furthermore, more than half the policies were submitted by agents who know pretty well which of their customers will be denied or quoted the higher exclusionary rate, so they save both the customer and themselves the trouble of applications that are certain to result in no sale. Even for those who are healthy, merely quoting the best rate possible will abort the application process because the best case is unaffordable.

And I have a big problem reconcilling the 2007 report's data for NH now that my premium for a $5000 deductable plus 20% of the next $5000 PPO insurance is $9400 a year for one person, well above the figures suggested in the report. And NH has essentially no requirements other than the insurer must prove it isn't a scam.

So, Caplan's On further reflection, the fact that health insurance is too expensive for the poor is actually an important argument for deregulation of the health industry in order to bring costs down. fails to account for the high cost of insurance in NH vs the lower costs in the now extremely highly regulated Mass where many in NH get their expensive speciality care that can only be afforded with insurance.

I have checked the rates south of the border in Mass, and if I could pay Mass income tax and thus qualify for a Mass policy, I'd save money, even staying my high NH property taxes. If selling in NH and buying in Mass were a costless transaction, I'd save on the combination of taxes and health costs, reducing them to well under 50% of my income from their current 55-60%.

As for Caplan's Of course, if the problem is that you want to buy insurance against the possibility of becoming a high-risk customer, you should pick a company that lets you lock in your rate. I've had health insurance continuously for 35 years with only one break as I was forced from employer coverage to individual with the same insurer 6+ years ago, and never have I had the option to lock in a rate.

Perhaps Caplan thinks it is a good thing to place increasing burdens on people as they get old. But as the market doesn't actually work as Caplan theorizes even if not regulated, the older workers are driven to do everything possible to hold onto their ERISA benefit jobs, and their bosses who are also older will justify keeping older workers by advancing their theory that older workers are worth more than their costs while young workers cost more than they are worth.

(Decades ago, my coworkers would discuss the old guy who suddenly appeared in our group with no apparent function - now I wish I had an older manager who would do that for me.)

In other words, older workers are frozen into their jobs if they can keep them, whether they want them or not, thus preventing younger workers from integrating into the workforce naturally.

In many professions, especially many engineering ones, the workforce is dominated by boomers, and usually the older end, who will rapidly leave in the next decade as they reach 65-70. The fall in asset prices will certainly delay their leaving willingly, but that will only make their retirement all the more of a problem.

Thus the current model for insurance in the US excludes many older people from having insurance and greatly restricts a free market in labor because even the bosses need to protect their personal ability to obtain health insurance by protecting older workers as a class.

Michael, the reason employer based healthcare is so much cheaper is that it enjoys a massive tax break. It is immune from payroll, income, and corporate taxes. Thus it is much cheaper.

Michael, the reason employer based healthcare is so much cheaper is that it enjoys a massive tax break. It is immune from payroll, income, and corporate taxes. Thus it is much cheaper.

Not so. When your company's HR department enrolls you in its group plan, it writes a check to the insurance company for an amount much less than what you would pay individually for the same plan. The health insurance company couldn't care less whether or not the check it is cashing comes from taxed proceeds or not. It is just trying to maximize its own profits.

Aside from potential adverse selection, another likely reason for the cost difference is simple bargaining power. When you travel at company expense, you may be able to book hotels or rent cars for cheaper than you would if you were on your own. Same principle.

ogmb: "If the government were only interested in getting high-risk drivers & patients insured, it would simply implement a mandate to provide insurance,"

35 of the 50 states require health insurors to participate in a high risk pool. The premiums for those enrolled in the high risk plans are set by the state - generally at 1.5 to 3 times the average rate in the state for individual polcies. Most states have waiting periods, and a few have waiting lists. Still, in 70% of the states, governments have implemented mandates to provide insurance.

Health insurors did not willingly provide policies to the high risk patients at the state-mandated rates. So we can assume that insurors are losing money on these patients, and that insurors must charge higher rates to their other customers. In at least 35 states, high risk patients are being subsidized by other insurees.

Ricardo wrote: Not so.

Richardo, yes it is so. Peter was simply saying that companies buy health insurance with pretax dollars but individuals buy it with after-tax dollars. Do you disagree with this?

Phil: "Most health insurance is NOT insurance. Insurance is an arrangement where one trades an elective, certain, frequent, regular, insignificant payment for an unelective, uncertain, infrequent, irregular, significant payment."

Health insurance contracts cover both recurring as well as non-recurring treatment, significant as well as insignificant expenses. The insignificant and recurring expenses are a small fraction of the costs incurred by health care providers. You seem to be arguing that this small part of the health insurance contract somehow "disqualifies" the policy from being properly categorized as "insurance".

Doesn't it make sense that insurors would desire their customers to receive routine care? Early detection of diseases such as diabetes, hypertension, and prostrate cancer results in far cheaper treatment, and thus reduced costs for the insuror. That such routine care also benefits the insuree should be obvious.

If both the insuror and the insuree benefit from the inclusion of routine care in the insurance contract, why should anyone object? and what difference does it make what we call such health care policies?

Of course, if you want to argue semantics then consider this definition offerred by Merriam-Webster:

insurance - coverage by contract whereby one party undertakes to indemnify or guarantee another against loss by a specified contingency or peril

I see nothing in that definition which restricts its application to "uncertain, infrequent, irregular, or significant" events.

When I was a kid, there was money everywhere. My great grandpa was a lawyer for the Chicago mob in the 1920s, and today, my dad's generation is still living off that money. Sometimes I wonder if the key to being able to squash materialism is to have a lot of it as a kid. I'm not sure. But let me tell you this: I grew up with a laundress and a housekeeper and unlimited cash from a drawer in the dining room.

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