Adverse Selection — California Style

Posted by Nolan Miller on Feb 9, 2010

Filed Under (Health Care)

News from the West Coast today that Anthem Blue Cross, one of the largest private insurers in California, is raising the prices for the 800,000 or so people it sells individual health insurance policies by up to 39%.  The Obama administration is not happy, to say the least.  HHS Secretary Kathleen Sebelius fired off an angry letter to Anthem and its parent company, WellPoint, demanding an explanation.  Of course, this also comes at a time when the Obama administration is struggling to make the case that health insurance reform is urgently needed, so this also provides a perfect example for them.  The letter is kind of cool, since I have never seen an angry letter from a Cabinet Secretary before.  The text is here.

What I find more interesting as an economist, however, is WellPoint’s response.  They haven’t replied formally to the letter yet, but in a statement WellPoint’s spokesman said the following:

“As medical costs increase across our member population, premium increases to the entire membership pool result. Unfortunately, in the weak economy many people who do not have health conditions are foregoing buying insurance. This leaves fewer people, often with significantly greater medical needs, in the insured pool. We regret the impact this has on our members.”

So, where’s the economics lesson here?  In a competitive market, health insurance prices are driven by the cost of caring for the average person in the insurance pool.  That means that healthy people usually pay more than their actual cost of care and sick people pay less.  Although healthy people pay more than their average health expenditures in any year, they’re still willing to buy insurance because it provides them with, well, insurance.  In the event that they have a car accident or other unexpected, large expenditure on health care, they’re protected against the financial consequences.  This works fine as long as the premium (driven by the average cost of care) doesn’t get too high above what the healthy people are willing to pay for insurance against relatively rare events.

Now, enter the recession.  People are losing their jobs, wages for the employed are stagnating, and people are losing money on housing and financial investments.  In light of these challenges, some healthy people are looking at their health insurance premiums, their income, and the likely cost of going without insurance, and deciding not to buy health insurance.

This is a perfectly rational response to increasing premiums and decreasing incomes.  However, it results in the remaining people in the insurance people being, on average, sicker.  This means that the average cost of caring for the insurance pool will be higher, which will necessitate higher premiums.

Unfortunately (and interestingly if you study this stuff), this leads to the potential for what is known as an “adverse selection death spiral.”  The idea is that once premiums rise, the healthiest people who are still buying insurance may decide to drop out of the pool.  Since the remaining pool is even less healthy on average, premiums will once again need to rise to cover their higher medical needs.  And then the cycle starts over again.  In extreme cases, the premium just keeps going up until nobody is willing to buy insurance.

So, what next?  Well, the adverse selection story holds in competitive markets.  But, you can already see Secretary Sebelius telegraphing the administration’s punches.  They will argue that the price increases are not due to competitive pressure and an increasingly unhealthy insurance pool but rather a greedy, for-profit insurer trying to take advantage of people when they’re down.  For their part, WellPoint/Anthem will argue that this just shows why health reform is needed, but health reform of a fundamentally different sort than Obama has proposed.

My prediction is that we’re headed for a highly charged series of Congressional hearings that boil down to an attempt to drive home to voters that something needs to be done.  Really went out on a limb, there, didn’t I?