Monday, October 6, 2014

Adverse Selection

When I talk about economic understanding, I mean the ability to trace large economic or business decisions back to how they affect you and me as individual consumers and taxpayers.  There is no free lunch, no magic money tree; every time money is spent, it comes out of someone’s wallet.

This understanding seems especially difficult when it comes to insurance.  People are led to believe that they can pay small insurance premiums and receive larger returns.  AARP advertises that their Medicare supplement insurance “could save you thousands of out-of-pocket costs.”  How likely is that to happen when every insurance company must collect in total more than they pay out just to be able to pay their employees, to buy their office equipment, and to pay their rent and utility bills?  If their average customer saved thousands, where does that money come from?  Sales pitches like that drive the misunderstanding.

To add to the confusion we are led to believe that insurance availability is synonymous with healthcare availability, that insurance quality and affordability are synonymous with healthcare quality and affordability.  When it doesn’t work out that way, politicians and the press join in mutual head scratching.

So when someone comes up with the idea of adding individual choice to healthcare and health insurance, on first blush it sounds like a good idea.  Why would a man or elderly woman want to pay for pregnancy coverage?  Could I sign a contract with my doctor promising not to sue in return for a lower bill?  These and other similar programs could keep my premiums lower and really save me thousands.  Unfortunately the law will not allow this nor would it work in the insurance business because of a concept called adverse selection.

Adverse selection occurs when a product or service is selected by only a certain group of people who offer the worst return for the company.”  As a simple example, I had a work colleague whose wife became pregnant late in the year, just at the time when everyone at the company was selecting coverage for the following year.  He said that he was dropping the lower-cost high deductible plan and was willing to pay the higher premiums for the next year because of the anticipated expenses.  The next year he intended to switch back – good for him, bad for the insurance carrier.  If many people take similar actions, the insurance company must raise premiums or go out of business.  Likewise, if healthy people are allowed to go without insurance and pay their own doctor bills, insurers would not be able to collect premiums from them.  Since the insurance companies simply cannot afford to pay out more than they collect on a regular basis, there must be enough people paying in more than they are getting out to support the company’s expenses.  Forget about those exorbitant profits for “big insurance”; this is true even for a non-profit company.

For a long time companies would not insure people with pre-existing conditions.  Why?  It was their way to limit the pool of customers who were collecting more than they were paying.  As they are forced to accept them as customers, the increased cost is spread over all their customers.  The insurers can no longer weasel out of paying, but we don’t want them to go out of business either – or no one would be covered.

This is the situation we find ourselves in.  Because everyone is required to have insurance, overall health is a public concern.  Everyone’s health is everybody else’s business.  Those who don’t try to take care of themselves are a financial burden on the rest who are forced to subsidize them.  This is neither good nor bad; it just is the way things are.  People need healthcare, and people get healthcare, but the money doesn’t grow on trees – even if it comes from government subsidies.  We need economic understanding about insurance to see what is happening and to anticipate the benefits and ramifications of future proposals.

The next time you hear those ads for term life insurance that assure you that no physical exam or health questionnaire is necessary, think about what that means in terms of costs.  Such a deal will be especially attractive to those who want to avoid a physical exam.  As a healthy person with an average life expectancy, you would be required to subsidize them through your higher premiums.  You can likely find a cheaper policy to protect you from an unforeseen tragedy, if it is one that protects the company against adverse selection by asking about your health first.  That’s the way it works.

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