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What is adverse selection anyway?
Let me again cite Alex's strong arguments against the importance of adverse selection in insurance markets. Here is Paul Krugman, and here is Brad DeLong, both of whom see adverse selection as the central health care problem.
How can we square these differing points of view?
When I argue that adverse selection is not the key, I hear a common response: "*You* try getting insurance after you have been diagnosed with an advanced brain tumor," or something along those lines.
To be sure, this is a real point but it is not adverse selection. Adverse selection requires asymmetric information, namely that I know more about my brain tumor than does my potential insurance company. The more likely problem is that the tumor is common knowledge, or would be if I applied for insurance, and the company won't sell a policy for any price cheaper than the costs of treatment. There is no asymmetry of information, rather insurance simply is no longer possible. In the limiting case, imagine that a predictor-demon could forecast your lifetime medical expenditures with certainty, and then blog them by your social security number. Such a person, no matter how healthy, couldn't buy insurance either.
Scream all you want, but that is not inefficient per se (don't complain in the comments about the limits of the efficiency concept, and the cruelness of economists, I'm already on that one, scroll down to #7 under "microeconomics", alternatively you might make a complicated Rawlsian argument.) Covering these people, by the use of government policy, is a transfer, not an efficiency improvement, with an added caveat for imperfect capital markets.
Defenders of the adverse selection argument in reality believe the following: if someone is going to face death, or a very bad medical outcome, and can't buy their way out of it, government should put up the money, at least within limits.
Maybe yes, maybe no, but now we are comparing competing investments and which will bring the greatest utilitarian good and the greatest moral good. I'm far from convinced health care access wins that race or even comes in second.
And that is a general point, it is not about the United States and whether we pay more to get less compared to Europe, and so on. Please don't bring up that comparison to distract yourself from the logical force of this point or to think you can get a free lunch. If you wish, think of it as whether the Netherlands should subsidize as much health care as it does.
The point is this: defenders of the single-payer system, by invoking adverse selection, wish to claim efficiency on their side. If the single-payer system were more efficient, we would not have to worry about competing investments, in fact we could make more of such investments by moving to a single payer.
But what looks like adverse selection is in reality something just a wee bit different. That wee bit, however, is an important bit. The desirability of the supposed remedy follows from an ethical judgment, not the prospect of a Pareto improvement. And then we are back to comparing alternative investments for scarce resources.
I see the big marginal gains in lifestyle and in pharmaceuticals, not in access to health care per se. And that is another reason why I am skeptical of the single-payer arguments. That is without even considering the possible secondary consequences of so much government involvement.
I haven't dealt with the Rawlsian approach, which attempts to transform the ex post disaster into a case for ex ante insurance and thus returns us to the realm of efficiency. But if you reread the paragraph immediately above, that Rawlsian move, even if it succeeds on philosophical grounds (I am skeptical), still won't save the case for a single-payer system.
Posted by Tyler Cowen on February 5, 2007 at 07:17 AM in Economics | Permalink
Comments
It seems to me that the only validity in the adverse selection argument is to point out that a larger insurance pool would aid in lowering health care costs. In my view, that means barring state regulations and allowing a national insurance market. Maybe 20 per cent lower costs could be gained by this action.
Posted by: ChrisM at Feb 5, 2007 8:23:05 AM
I like this post a lot.
Jeff
Posted by: Jeff Smith at Feb 5, 2007 8:27:09 AM
I just don't get this argument. The problem is that, fearing adverse selection, insurers exclude those with "pre-existing" conditions. This severely limits the exit options of health care consumers and thus the working of competitive markets in health care. In this sense, the problem of adverse selection matters a LOT: it shapes the way the health care market operates.
Posted by: Zaoem at Feb 5, 2007 8:46:37 AM
I'm not fully convinced by your argument -- a tumor which both you and your prospective insurance company causing them to deny coverage isn't adverse selection, but that doesn't mean adverse selection doesn't exist or isn't important.
People know a lot about their general state of health, how well they take care of themselves (diet, exercise, risky behavior of various kinds), how healthy their own relatives were as they aged, what diseases run in the family, and so on, and they can take this all into account when deciding how much to spend on coverage. Insurance companies do not, automatically, have access to this information. Some of it can be acquired, but without effort or cost.
And then there is the issue of uncovering factors that predict good or poor health. An individual may be completely unaware of these factors and there still may be an adverse selection problem. Suppose a person gets rate quotes from insurance companies A, B, C, and D, and A is the low bidder because it has not invested as heavily in research in to risk factors as B, C, and D. This is now an asymmetrical information situation -- the applicant now has information that insurance company A does not, namely, the prices B, C, and D proposed to charge for a policy. This asymmetry of information is functionally the same as the applicant knowing something about his health that insurance company A does not.
And, of course, the same is true if the factors identified are ones pointing toward a low risk of poor health. Suppose company D offers the lowest rates to people particularly likely to remain healthy because its crack research and actuarial department has identified previously unappreciated 'non-risk factors'. It makes appropriately low bids and pulls healthier-than-average people out of the risk pools of companies A, B, and C.
Posted by: Slocum at Feb 5, 2007 8:48:14 AM
It's not "adverse selection" in the strictest, "Market for Lemons" sense, but it seems to me to be somewhat-related phenomenon. To quote Delong:
Insurance companies work like dogs to avoid selling insurance to people who are expensively sick or likely to get expensively sick. As a result, a huge amount of people's work-time and information technology processing power are wasted on the negative-sum game of trying to pass the hot potato of paying for the care of the sick to somebody else. The more people separate themselves or are separated into smaller and smaller pools with calculably different exposures to risk, the worse this problem gets.
That's not adverse selection, but it's a problem. It just doesn't have a name yet.
And surely the fact that I can buy insurance cheaper as a member of a group than as an individual means there is some real adverse selection going on, even if it isn't at the point of a death spiral.
Also, it's not so much that we liberals think that adverse selection is a big problem in the health care markets NOW. The employer provided system, for all its shortcomings, mostly eliminates the problem. It's that we fear it taking hold under libertarian health care proposals such as Kling's.
Posted by: Brock at Feb 5, 2007 9:08:58 AM
Playing games with language. When people say "adverse selection" is the problem, they mean the steps that the insurers take to avoid adverse selection.
Posted by: Anderson at Feb 5, 2007 9:17:46 AM
Suppose company D offers the lowest rates to people particularly likely to remain healthy because its crack research and actuarial department has identified previously unappreciated 'non-risk factors'. It makes appropriately low bids and pulls healthier-than-average people out of the risk pools of companies A, B, and C.
Ah, but in the long run, how bad a thing is that? If that means that insurance company D grows larger, and A, B, and C lose money, then that may be a bad thing for A, B, and C, but not necessarily for the insurance industry and society as a whole. You have to separate adverse selection for the entire market from competition among insurers. The healthier than average people are not unable to buy insurance, as in the real adverse selection case. Instead, they get cheaper insurance, whereas the sickier than average people get more expensive insurance.
In a situation where people "know a lot about their general state of health," this is at least a better outcome than a regulated private insurance market that causes healthier people to not buy insurance at all. That's the case in NY and NJ, where insurance companies essentially are not allowed to take prior conditions into account. (A single payer market is a different case that must be addressed separately.)
Also, a better understanding of risk factors and what causes disease is a useful thing, after all, and not totally wasted. Someone who better knows what causes diseases can take steps to change behavior to avoid it, or, if it is unavoidable, steps to mitigate the disease. That applies even to diseases that run in families. You may not think that the insurance company is the best party to spend that money, but I don't think that it's totally wasted, as people imply. (Insurance companies also spend lots of money encouraging people to get exercise and preventive care for similar reasons.)
how well they take care of themselves (diet, exercise, risky behavior of various kinds)
Of course, to the degree that how well people take care of themselves affects things and creates adverse selection, there's room for improvement in health and reduced health care spending by individuals shouldering more of the costs themselves. And, conversely, the greater the problem would be caused by a system that bans insurance companies attempting to figure out how well people take care of themselves in order to charge them for it. The "how well they take care of themselves" does create a problem of adverse selection, but, to the degree that people can change their behavior, it also argues that the effort spent by insurance companies to determine it is not really in vain.
It also implies that a problem exists with single-payer health care as well, since people would have less incentive to take care of themselves. And therefore, of course, a single-payer health care plan would also spend lots of money to determine what risk factors exist for disease, and encouraging people to reduce them and engage in healthier behaviors. Just as insurers do. So the inefficiency exists in both cases.
Posted by: John Thacker at Feb 5, 2007 9:54:30 AM
And surely the fact that I can buy insurance cheaper as a member of a group than as an individual means there is some real adverse selection going on, even if it isn't at the point of a death spiral.
1) Most people get insurance from their employer.
2) The better the job, the more likely it comes with health insurance.
3) Therefore, people who have employer-provided insurance tend to be wealthier (and better educated) than others with otherwise similar demographics.
4) Being wealthier and better educated is correlated with better health and better health-maintaining behaviors.
5) Therefore, currently, not having employer-provided health insurance is an identifiable risk factor for poorer health.
6) Therefore, one expects individual insurance rates to be higher.
Of course in some states, such as NY and NJ, where well-intentioned law prevents insurers from considering pre-existing conditions, individual health insurance is much, much more expensive. In those states adverse selection certainly does exist.
Posted by: John Thacker at Feb 5, 2007 10:00:24 AM
One minor point is that you seem to be bootstrapping an argument about
adverse selection into an argument against single-payer. Single-payer is
far from the only remedy for adverse selection, and there are many reasons
to favor single payer that have nothing to do with adverse selection. So
apart from the validity of your point, I don't think it carries as much
weight against single payer as you think it does. (I'm also not sure where
you get the idea that single-payer advocates in general think there's a
"free lunch" to be had, but that's probably another discussion.)
More importantly, as some have already noted, is that you're drawing
a distinction between adverse selection and price discrimination (which is
reasonable as far as it goes), and then based on that seem to be jumping
to the conclusion that adverse selection either doesn't exist or isn't a
significant problem.
If you're arguing the latter, your conclusion doesn't hold up, i think, absent some evidence that (1) adverse selection (as you define it) is a rare and/or low-cost problem;
or (2) that there are Pareto efficiency gains associated with price
discrimination (as you define it) that offset any costs associated with
adverse selection. Absent that kind of evidence,,aren't you just inserting
your best guess in lieu of someone else's?
I think what you're saying is just that the phenomenon we often think of
as adverse selection in health insurance (a form of market failure) is
really price discrimination, and therefore something that's not necessarily
incompatible with economic efficiency. That might be right, in terms of
economically valid pricing strategies for health insurers; although, again,
because you're a good economist you've framed your question in terms that
should be quantitatively answerable - and until that evidence is in, isn't
it a matter of judgement - not economics - whether to draw the conclusion
you do that a single-payer scheme wouldn't increase Pareto efficiency in
health insurance?
I have a bunch of more fundamental objections, too, but lack the time or
fluency to compose them right now. Anyway, the post makes a good &
provocative point - i just think you're drawing much too strong conclusions
from it.
Posted by: TW at Feb 5, 2007 10:02:32 AM
I should also point out that holding a good job may also point to other harder to measure factors that may be associated with better health.
I do have a related question about single-payer health insurance. There are various risk factors and behaviors associated with poorer health-- take smoking as one of them. How far do you want a single payer health insurance provider to go in not "wasting" money determining who has various factors or behaviors? In the single payer health plans I'm familiar with, smokers do not pay any sort of extra tax or premiums or anything, and nor do anyone else with other risk behaviors.
Plenty of risk behaviors are fun. Clearly that seems to present some sort of moral hazard difficulty when the cost is reduced. Obviously, the health provider can spend money trying to reduce the incidence of such behaviors, although that ends up seeming fairly close to what many insurance companies do now.
If a single payer health insurance provider does charge for those behaviors, then that involves the spending of sums of money to determine who is engaging in them, again like insurance companies now. On the other hand, if the behaviors are simply prohibited or things caused by them are not covered, then we have a similar problem to the pre-existing condition problem now, except that insurance might even be more unobtainable.
I note that Europe and Japan, all with single payer health insurance, have a much higher percentage of smokers, particularly among the educated and wealthy, despite their larger and more obvious health warnings.
Posted by: John Thacker at Feb 5, 2007 10:30:53 AM
I agree with the argument about adverse selection, but it’s important to distinguish between Pareto efficiency and overall utility here. A government transfer of wealth in order to provide poor people with health care may not be a Pareto improvement, but it is still likely to be an overall utility improvement, because of the declining marginal utility of wealth.
It’s probably true that much of our current health care spending is inefficient, but that’s an indictment of the current system we have. It’s not an excuse for letting people go without access to health care.
Access to basic, non-emergency room health care means better prevention and treatment of chronic diseases, and also earlier detection and treatment of acute diseases. These things make a huge difference in one’s quality of life. The idea that there are some hypothetical ‘competing investments’ which would result in greater utilitarian or moral good seems pretty dubious, particularly since Tyler’s post makes no effort to spell out what those competing investments are.
Posted by: RC at Feb 5, 2007 10:33:34 AM
Several characteristics of the health insurance market have been confounded in Brad de Long's post and here. Administrative costs for private insurance add to the cost of health in this country relative to nationalized systems. However, the major cost difference between the United and other industrial countries appears to be the higher prices of medical services. A recent article in Health Affairs documents the importance of higher wages for health professionals in the cost difference. Adverse selection is an issue that any health insurance market has to manage absent a mandate that all persons enroll in plans with uniform benefits. The claim that the cost of underwritting is the major cause of the considerably higher administrative cost (compared to national systems) of private insurance generally or non-group insurance in particular is unsubstantiated however these costs are not trivial either. Underwritting costs and selling costs increase the administrative cost of non-group insurance above the cost of large employer group insurance probably by 20% or more and billing, collection and profit increase the cost of even very large group and Medicare Medicaid compared to national insurance schemes. A single payer scheme here would result in lower costs administrative costs per capita but would judgeing from the experience of other countries and Medicare would not lower the rate of growth nor achieve anything like the cost of care in other countries unless market returns for health care providers were reduced. Allowing a so called national market for health insurance if it is taken to mean disallowing rules that limit cost sharing would lower the premiums for some but raise premiums for others. Most state coverage mandates cover services typically offered in employer plans not subject to state mandates (ERISA plans) and these mandates most likely add little to the health premiums. See for example the CBO analysis.
Posted by: Sonia at Feb 5, 2007 10:37:10 AM
"Maybe yes, maybe no, but now we are comparing competing investments and which will bring the greatest utilitarian good and the greatest moral good. I'm far from convinced health care access wins that race or even comes in second."
And that's the key problem here. The idea that this tradeoff is essentially a lifestyle/pharmaceutical issue is morally indefensible. I wrote a half dozen obvious and clear cut examples but deleted them when I realized that you understand them already, you just don't give a damn.
I think John Holbo needs to do one of his trademark vivisections of this post.
As I observed previously, the essential philosophical imperative of Tyler Cowen's health care position is to keep costs as low as possible for healthy people. That's all it is, and there's nothing at all noble about it.
Posted by: Russell L. Carter at Feb 5, 2007 11:07:56 AM
John - about your smoking issue...
I may be wrong, but I believe up until recently, in most of the Europe and
Japan, the dominant tobacco company was state-owned. In certainly in much
of Europe, the tobacco shops were state-owned as well. So, perhaps there was
a conflict: sell as much tobacco as humanly possible. It also seems to be
taxed at a less onerous rate than in the US, again, with the presumption
that they should maximize the selling of tobacco, not necessarily the price
or tobacco, to penalize, as it were...
It just seems inevitable, that one way or another, the healthcare consumers
will become more and more responsible for the amount they are spending on healthcare. And overall, this is clealry a good thing. So, as a tangential
issue doesn't it make sense that the country should also re-think euthanasia?
Posted by: glenn at Feb 5, 2007 11:16:21 AM
The adverse selection narrative makes no prediction about the cost of health care itself; it makes predictions about the relative costs of health care and insuring against health care expenses: to the extent that adverse selection is a problem, the cost of insuring against health care approaches the cost of paying for health care out-of-pocket for every individual.
The total cost of health care is irrelevant to whether adverse selection is taking place or not.
Posted by: Cyrus at Feb 5, 2007 11:33:09 AM
Excellent post.
I'd like to see you tackle moral hazard next, since it is also often misdiagnosed.
If I rely on my doctor to make judgements about what medical care is needed, then it's my doctor's utility and judgement, not mine, that needs to be "incentivized". (Sorry for the awful verb.)
Posted by: John Horowitz at Feb 5, 2007 11:34:29 AM
Out of curiosity, has there been any attempt to apply Robinson-Patman to medical service providers that bill different amounts depending on who's paying the fee? (Medicare / a preferred insurer / another insurer / an uninsured patient)
Posted by: Cyrus at Feb 5, 2007 11:43:31 AM
That there would be no gain in efficiency under a single-payer system is true only if one assumes that switching to a single-payer system has no effect on the sorts of proceedures and care provided.
That is likely (and hopefully!) a false assumption.
Under the current system, there is little incentive for healthcare providers to invest in preventative care. See Phillip Longman's article in the Washington Monthly on the VA for lots of good details on this (Link). Essentially the argument is that there's no good reason to spend current dollars to reduce the risk of a future payout that can either be denied, or may end-up on someone else's insurance rolls by the time the disease is likely to hit.
If everyone is in the same risk pool, this is no longer the case. Any money spent to reduce long-term disease risk will reduce overall costs for the single insurance provider (assuming that reduction vs. treatment is cost-effective, which is most often the case). Thus, for a single payer there is substantial incentive to include and encourage preventative care which is absent in the case of a many-provider solution.
So you are correct in that this is not an example of adverse selection, but it does address your argument that a single payer system is unlikely to produce gains in efficiency.
Posted by: TW Andrews at Feb 5, 2007 12:09:02 PM
Thus, for a single payer there is substantial incentive to include and encourage preventative care which is absent in the case of a many-provider solution.
Why? The single payer is under no competitive pressure to reduce its costs, or those of its patients. It's not as though the government is going to let the single payer go bankrupt.
Posted by: Cryus at Feb 5, 2007 12:25:44 PM
Good post.
I think there are actually two issues that are often combined, but really shouldn't be. The first is whether health insurance is a market that essentially breaks down, which would make it a case for government handling (like roads or police, etc.). The second is whether the government should help people buy medical treatment (which is different than "health care") when they don't have the money to buy it themselves (which could be because of poverty or high costs or both). To me, it seems like the second issue is the real meat and potatoes, while the first issue is just a means towards those ends.
The problem is that I think many in the Delong/Krugman camp are making a case for the first one while ignoring other ways of achieving the second one. But like most areas of my life, before I concede vast new powers to my usually-inept government, I'd like to see the first issue settled beyond almost any doubt, which this post shows is clearly not the case. I would much rather try other ways of addressing the basic problem of people who can't afford their medical expenses before giving up complete control of my medical care to the same geniuses that brought us Social Security and the Iraq war. For example, is there nothing along the lines of Jane Galt's "the government pays all/most medical costs exceeding X% of income" that could address many of the problems?
If Delong and Krugman would put serious effort into non-single payer proposals, I'd find it a lot easier to take the economics of their single-payer proposal at face value. But until then, I find myself wondering if the economics wasn't tuned to justify single-payer, rather than single-payer being the outcome of a rigorous economic analysis.
Posted by: Josh at Feb 5, 2007 12:28:09 PM
There is a real problem here, but I agree with Tyler that "adverse selection" isn't the right name for it. The problem is that most Americans now live with the assumption that someone else should protect them from Anything Significantly Bad. Whether it's a brain tumor, an unhealthy diet, predictable flooding, or the price of gas, people expect some combination of the government, multinational corporations, or insurance companies to bail them out of the consequences of both their bad luck and their poor decisions. And this expectation exists even when people sign explict contracts to the contrary or when people decline coverage entirely!
This "adverse events" problem is the #1 reason why I am not a libertarian. As much as I might like a libertarian world, I don't live in one, and people who are free to smoke and to build homes on barrier islands are going to cause my taxes to go up, since the government cannot reliably pre-commit iself to not paying the costs of their future mistakes.
Requiring everyone to buy catastrophe insurance strikes me as a realistic compromise.
Posted by: DK at Feb 5, 2007 12:59:36 PM
There is a simple disagreement on facts here. When Delong says "Insurance companies work like dogs to avoid selling insurance to people who are expensively sick or likely to get expensively sick," he is pretty much in direct contradiction to the article Tabarrok linked.
I think Tabarrok is right and Delong wrong. But it is true that insurance companies do a lot of rent-seeking, trying to avoid paying what they owe. So I think insurance companies are a big problem, but it doesn't make a difference whether they're individual or through a company. (A company may supply an office to fight with the insurance for you, but that's rent-seeking, too.) Catastrophic insurance is a way of reducing the role of insurance companies. The clinics TC linked to recently are another method, and I think that's why they're cost-effective.
But the first thing is to resolve the factual question. It not so hypothetical that it can't be resolved.
Posted by: Douglas Knight at Feb 5, 2007 1:18:50 PM
I think this is where the central insight from Nyman about the wealth benefit of health insurance comes into play.
Posted by: RSaunders at Feb 5, 2007 2:24:42 PM
But under all this logic, if the system were to play itself out to its eventual conclusion, why would anyone want to BUY health insurance. If an insurance company wants to sell you insurance, that is because it knows it will make more money than it spends on you. Thus, you'd be better off banking your money and saying screw-off to the insurance company. If the insurance company won't sell you insurance, it means you need to save up your money for the inevitably health catastrophe you will eventually face.
Either way, insurance is useless to everybody except the insurance companies. And that's what's wrong with the system. Only one person can win the insurance game - you or the insurer. If the insurance company has the odds stacked entirely in its favor, betting on insurance is like betting on "Pink" at the rolette wheel. You'll never win.
Posted by: Zifnab at Feb 5, 2007 3:03:48 PM
Thus, for a single payer there is substantial incentive to include and encourage preventative care which is absent in the case of a many-provider solution.
--> Why? The single payer is under no competitive pressure to reduce its costs, or those of its patients. It's not as though the government is going to let the single payer go bankrupt.
Because the single payer reaps the benefits of reduced payouts resulting from greater preventative care. Even without it reducing its costs, it has an incentive to encourage preventative care.
Posted by: TW Andrews at Feb 5, 2007 3:22:45 PM
