Does the Nobel Prize committee know something health insurance markets don’t?
In November, Joseph Stiglitz, George Akerlof, and Michael Spence shared this year’saward for economics, primarily for their academic contributions to the economics of“asymmetric” information.
Theory Makes Bad Policy
Columbia University’s Stiglitz is particularly noted for his emphasis on the possibility ofmarket failure in competitive health insurance markets because of adverse selectionand imperfect information. But his market skepticism has had its own adverseconsequences, bolstering support for policies favoring more government regulation andless consumer choice.
In a seminal 1976 article, co‐authored with Princeton economist Michael Rothschild,Stiglitz observed that if insurance buyers know more about their own health than doinsurers, then buyers who know their risks are greater than average will purchase moreinsurance when it’s priced based on average risk. Buyers who know their risks are lessthan average will purchase less insurance. This sequence of events is termed “adverseselection.”
Over time, insurance premiums will increase as those with risks less than average self‐insuremore often and more extensively. In the worst‐case scenario, the overall healthinsurance market can break down completely.
Twenty‐five years ago, Stiglitz wrote, “Do these theoretical speculations tell usanything about the real world? In the absence of empirical work it is hard to say.”
Unfortunately, health care policymakers have generally acted as if adverse selectionwas a dominant reality and not just a theoretical curiosity. Such thinking providedlegitimacy for all sorts of regulatory interventions and compulsory health insuranceschemes that favored equity over efficiency and risk‐spreading over personal healthmaintenance incentives.
Government Failure, Not Market
By exaggerating the relative significance of adverse selection in health insurancemarkets, pro‐regulatory forces could blame inefficient markets for leaving parts of thepopulation uninsured.
Market‐oriented reforms like medical savings accounts, defined contribution healthplans, and Internet‐based individual insurance options have collided with worries thatthey would increase adverse selection and make health insurance unaffordable for thehigh‐risk people “left behind” in traditional employer group plans featuringcomprehensive coverage.
To ward off such adverse selection, consumers are denied a level playing field approachto market‐priced health care alternatives. They must maneuver past artificial barrierslike mandated benefits, modified community rating, restrictions on risk classification,and regulatory cross‐subsidies, as well as tax policies biased toward employer‐sponsoredgroup health insurance.
Ironically, public policy barriers to competitive choices in health care representgovernment failure –built not only on imperfect information, but on deeply flawedassumptions.
Adverse Selection Doesn’t Apply
There’s little evidence that individuals and families can identify and anticipate most oftheir future medical expenses in ways potential insurers cannot.
In a study forthcoming from the Cato Institute, James Cardon and Igal Hendel find littleempirical evidence of information asymmetries, market failure, and adverse selection inhealth insurance markets. They note that differences in health expenditures betweenthe insured and uninsured are mostly due to observable differences in demographics(age, gender) and price sensitivities (higher‐income workers capture more taxsubsidies for insurance coverage), rather than unobservable factors related to healthstatus.
Private insurers aren’t helpless or clueless when it comes to adverse selection. Theymay use such tools as setting limits on plan switching, varying premiums according tothe amount of insurance purchased, underwriting and rating based on risk categories,creating more homogeneous risk pools, or relying on the law of large numbers todiversify risks in large employer pools.
Consumer inertia, individual differences in aversion to risk, and the administrativecomplexities and costs involved in making risk adjustments within group health plansall further limit the applicability of adverse selection theory to the actual healthinsurance world.
Many of the difficulties we observe in health insurance markets are due to governmentintervention rather than adverse selection or other market failures.
If insurers are not allowed to charge different premiums to different risks incompetitive markets, they may resort to excluding or discouraging coverage of highrisks. Cream‐skimming (selecting only the best risks) becomes the insurers’ mirrorimage of adverse selection by insurance customers.
Political interventions in health insurance markets don’t alleviate underlying differencesin risk across customers or eliminate insurers’ knowledge of such differences. They onlyforce insurance companies to cope in inefficient ways and create new problems.
Health status information is most likely to be asymmetric when it is scarce and costly.While government mechanisms prefer to ignore, hide, or shift those information costs,markets create proper incentives to discover efficient ways to signal relevant privateinformation and put it to use.
Need for Reform
Market mechanisms can’t eliminate every unfortunate human experience in health careaccess, affordability, and quality. Private charity and a backup safety net oftransparent, direct subsidies have necessary roles to play.
Beyond a certain point, any reductions in adverse selection will cost more than they areworth. But we do need to open more breathing room for market innovations to fill thereal gaps that exist in insurance coverage. Effective reforms include bolsteringincentives for new forms of voluntary risk pooling and long‐term insurance contracts,deregulating insurance choices, and providing tax equity for all insurance purchasers.
The growing availability of online health information and insurance products furtherstrengthens the case for empowered consumers. Unlike centralized government“solutions,” markets don’t promise perfect outcomes, just better ones.