1. Adverse Selection

2. 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.

3. 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.

4. 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.”

5. 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.

6. Insurance pricing with separate groups of consumers Premium per: InformationPricing approach High Risk (100 people) Low Risk (100 people) Total premiums paid Total benefits paid out Net profits to insurers FullSeparate$1,500$150$165,000 (100 x $1,500 + 100 x $150) $165,0000 The insurance company collects $1500 x 100 from the high risks, and $150 x 100 from the low risks. Total premiums of $165,000 equal expected costs. The premium to the high risks is therefore 5% x $30,000. For the low risks, it is 0.5% x $30,000. It therefore charges separate prices to each group; competition forces it to charge an actuarially fair price. With full information, the insurance company can tell the high risks from the low risks. Failure of Different Insurance Strategies

7. Insurance pricing with separate groups of consumers Premium per: InformationPricing approach High Risk (100 people) Low Risk (100 people) Total premiums paid Total benefits paid out Net profits to insurers FullSeparate$1,500$150$165,000 (100 x $1,500 + 100 x $150) $165,0000 AsymmetricSeparate$1,500$150$30,000 (0 x $1,500 + 200 x $150) $165,000-$135,000 The insurance insurer collects $150 x 100 from the high risks, and $150 x 100 from the low risks. Total premiums of $30,000 are $135,000 less than expected costs. In this case, the insurer loses money, so it will not offer insurance. Thus, the market fails; individuals will not be able to obtain the optimal amount of insurance. The high risks have no incentive to tell the insurer about their disease, however; they pay 10 times as much if they reveal truthfully about their status. It could continue to charge separate premiums to the different groups, taking the person’s word that they are either healthy or ill. Now imagine the insurance company cannot tell people apart. This is a case with asymmetric information. Failure of Different Insurance Strategies

8. Insurance pricing with separate groups of consumers Premium per: InformationPricing approach High Risk (100 people) Low Risk (100 people) Total premiums paid Total benefits paid out Net profits to insurers FullSeparate$1,500$150$165,000 (100 x $1,500 + 100 x $150) $165,0000 AsymmetricSeparate$1,500$150$30,000 (0 x $1,500 + 200 x $150) $165,000-$135,000 AsymmetricAverage$825 $82,500 (100 x $825 + 0 x $825) $150,000-$67,500 With this price structure, none of the low risk people buy the policy. The insure collects $825 x 100 people, but pays $1,500 x 100 people in benefits. Again, the insurer loses money, so it will not offer insurance. Thus, the market fails again with a pooling equilibrium. The average cost for the population as a whole would be $165,000 in claims divided by 200 people, or $825 per person. Another potential alternative is that the insurance company understands it cannot tell consumers apart. Thus, it charges a uniform premium for all customers. Failure of Different Insurance Strategies

9. 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.

10. 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.

11. 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.

12. 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.

13. 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

14. 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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