Adverse Selection What Is Adverse Selection Adverse selection

Adverse Selection

What Is Adverse Selection • Adverse selection in health insurance exists when you know more about your likely use of health services than does the insurer. • As a result, you have an incentive to use this information to your best advantage. In particular, if you have some health problem you might try to find an insurance plan that is designed for healthier people. • If you were successful, you would pay a premium that was less than your expected claims experience. The insurer, on the other hand, would probably lose money on you.

Adverse selection • People with a higher than average risk of needing health care more likely than healthier people to seek health insurance. • Adverse selection results when these less healthy people disproportionately enroll into an risk pool.

Death spiral • If a risk pool attracts a disproportionate share of people in poor health, the average cost of people in the pool will rise, and people in better health will be less willing to join the pool (or will leave and seek out a pool that has a lower average cost). • A pool that is subject to significant adverse selection will continue to lose its healthier risks, causing its average costs to continually rise. • This is referred to as a “death spiral. ”

Asymmetric Information • Assume there are 2 groups, each with 100 people. • The first group has 5% chance of getting diseased, and the second group has a 0. 5% chance. • The payout is $30, 000 when diseased.

Failure of Different Insurance Strategies With full. Itinformation, therefore charges the insurance The separate premium prices Thetoinsurance the high risks company is collects company to can each tell group; the high therefore competition risks from 5% $1500 forces x $30, 000. x 100 it from For the high low risks, and to charge anthe actuarially low risks $150 fair, price. itxis 100 0. 5% from $30, 000. the low risks. Total Insurance pricing with separate groups ofxconsumers premiums of $165, 000 equal Premium per: expected costs. Information Pricing approach High Risk (100 people) Low Risk (100 people) Total premiums paid Total benefits paid out Net profits to insurers Full Separate $1, 500 $150 $165, 000 (100 x $1, 500 + 100 x $150) $165, 000 0

Failure of Different Insurance Strategies It. Now could imagine continue thetoinsurance charge separate The insurance In this insurer the collects insurer loses $150 The high have no incentive to company premiums cannot telltopeople the different apart. risks groups, Insurance pricing with separate groups ofcase, consumers money, x 100 from so their itthe willhigh not offer risks, insurance. and $150 tell the insurer about disease , This is taking a case the with person’s asymmetric word that they Premium per: x 100 from market themuch fails; low risks. individuals Total they Thus, pay 10 the times as arehowever; information. either healthy or ill. will premiums not be able of $30, 000 to obtain are the $135, 000 optimal Information Pricing High Risk Low Risk premiums Total benefits Net profits if they Total reveal truthfully about their approach paid out expected insurers (100 people) lesspaid amount than oftoinsurance. costs. status. Full Separate $1, 500 $150 $165, 000 (100 x $1, 500 + 100 x $150) $165, 000 0 Asymmetric Separate $1, 500 $150 $30, 000 (0 x $1, 500 + 200 x $150) $165, 000 -$135, 000

Failure of Different Insurance Strategies Insurance pricing with separate groups of consumers Premium per: Information Pricing approach Full Separate average cost. Again, foristhe population insurer loses money, it Another The potential alternative With this that price structure, none ofso the Risk Low Risk Totallow premiums Totalinsurance. benefits profits The ascompany a whole would will berisk not $165, 000 offer in Thus, the. High insurance understands people buy the Net policy. paid out to insurers (100 people) claims divided byinsure 200 market people, fails or again a people, pooling it cannot tell consumers apart. collects $825 with x 100 $1, 500 $150 $165, 000 0 $825 person. equilibrium. Thus, it charges a uniform premium butper pays $1, 500 x 100 people in (100 x $1, 500 for all customers. benefits. + 100 x $150) Asymmetric Separate $1, 500 $150 $30, 000 (0 x $1, 500 + 200 x $150) $165, 000 -$135, 000 Asymmetric Average $825 $82, 500 (100 x $825 + 0 x $825) $150, 000 -$67, 500

Asymmetric Information • This example illustrates how the problem of adverse selection plagues the insurance market. • People have the option of buying insurance, and will only do so if it is a fair deal for them. Only the high risks take-up the policy so it loses money.

Does Asymmetric Information Necessarily Lead to Market Failure? • Will adverse selection always lead to market failure? Not if: – Most individuals are fairly risk averse, such that they will buy an actuarially unfair policy. • The policy entails a risk premium, the amount that risk-averse individuals will pay for insurance above and beyond the actuarially fair price. • This leads to a pooling equilibrium, which is a market equilibrium in which all types buy full insurance even though it is not fairly priced to all individuals.

Does Asymmetric Information Necessarily Lead to Market Failure? • Will adverse selection always lead to market failure? – In addition, the insurance company can offer separate products at separate prices, causing consumers to reveal their true types (careless or careful). • This leads to a separating equilibrium, which is a market equilibrium in which different types buy different kinds of insurance products.

Does Asymmetric Information Necessarily Lead to Market Failure? • The separating equilibrium still represents a market failure. • Insurers can force the low risks to make a choice between full insurance at a high price, or partial insurance at a lower price. • Although insurance is offered to both groups in this case, the low risks do not get full insurance, which is suboptimal.

Methods of limiting or adjusting financial risk A. "Carve-Outs" n Based on: • • • Type of service (eg, preventive care) Diagnoses or conditions (eg, AIDS) Referral specialty (eg, ophthalmology) B. Caps on Expenditures C. Risk-adjustment of capitation payments

Underwriting And Rate Making • Insurers deal with adverse selection through the underwriting and rate-making process. They seek to identify the determinants of claims experience and use this knowledge to put individuals and groups into risk pools that reflect their expected utilization. • The nature and extent of this underwriting process depends in large part on the rating techniques employed. • Community rating, in which everyone is in the same risk pool, requires little formal underwriting. Similarly, retrospective experience rating requires little underwriting; each employer group constitutes its own risk class.

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