Transcript F03-14-Problems with Insurance -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 are 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
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Failure of Different Insurance Strategies
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Failure of Different Insurance Strategies
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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"
 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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