Map of life expectancy at birth from Global Education Project.

Wednesday, May 03, 2006

Back to the file cabinets . . .

Okay, I have to finish up with this insurance stuff, however profoundly it may bore people, because it's important, damnit! I've discussed casualty insurance, then I've discussed how health insurance (which is only partly insurance, hence much confusion is caused by the name) is different with respect to the issue of moral hazard. Now we come to the issues of adverse selection and risk rating.

As you will recall, adverse selection is the obvious problem that people who think they are likely to suffer a casualty in the near future are more likely to buy insurance. In other words, if you are diagnosed with terminal cancer, you might just rush out and buy a life insurance policy. That would make selling insurance a losing proposition, unless insurers do one or both of two things: a) Refuse to sell to people who are at relatively high risk, or b) Charge higher premiums to people at higher risk. In practice, they tend to do a little bit of both.

Now, as we have also seen, although they have to do this, it makes their product less desirable. If they could do it perfectly, insurance would in fact be worthless. In the case of health insurance, if insurance companies could predict that your medical expenses in the coming year will be $7,862.56, that's what they would charge you for a premium, plus their administrative expenses and profit. So you wouldn't buy the insurance, you'd just pay the bills yourself, which would be cheaper for you.

In practice, the vast majority of people get insurance as part of a group, typically employees of a particular company. Let's assume there is no government regulation (which is counterfactual, of course). Then insurance companies would negotiate with employers over what product to offer and the cost. Companies would generally want the insurance to be available to all of their employees, or at least all of their employees at or above the pay grade that they want to cover, and they would want to get the same deal for all their covered employees. That's simpler for them, it avoids creating disgruntled employees, and it assures that all the company's valued employees will get health care. In that circumstance, the insurance company will charge the employer a premium based on the average risk for all its employees. In an unregulated market, they may adjust this based on the nature of the industry, and the employer's historic experience.

For example -- and this is absolutely true -- during the early years of the AIDS epidemic, florists were charged more for insurance on the grounds that their employees were more likely to be gay, and hence at risk for AIDS. Once an insurer has a relationship with a company, the premium may be adjusted each year based on experience. These procedures are called risk rating and experience rating. Also, in the real world, insurers typically won't provide coverage for new employees for "pre-existing conditions" -- diseases they already have when they join the company -- for some period of years. They don't want people choosing jobs that provide insurance that meets their needs (adverse selection, in other words).

(Wow, I am bored already myself.) People who don't get health insurance through employment have a problem in this system. Even if they could afford to pay the premiums an employer pays -- let's say the person is a self-employed consultant making big bucks -- insurers will want to charge them more, a lot more. The reason is that since they aren't part of a group, the insurer can't predict what they are likely to cost in terms of claims, and the insurer has to worry about adverse selection. Even a physical exam and medical history can't rule out that the person secretly knows they are at risk for some reason. And as we all know, they will do that exam and take that history and people who are indeed at high risk will be unable to afford insurance or won't be able to buy it at all -- and those are exactly the people who need it most.

(Whew, we're getting toward the end of today's post.) So, let's say there is no regulation, and insurance company A sells cheap policies to companies that employ mostly young, healthy people. Those companies will flock to company A for the cheap policies. Company B tries to charge all employers the same, but the customers who are least costly have all gone to Company A. So Company B has to raise its premiums. That causes employers who have middling costs to switch to Company A, which will offer them a middling rate. Company B has to raise rates to the remaining employers even further, and so it goes, till Company B is out of business and every company is paying based on its actual cost of providing health care to its employees. This is called the Death Spiral. The problem gets worse because companies with older and less healthy employees are at a competitive disadvantage. This tempts them to discriminate in hiring and termination; or else they have to drop insurance for their employees, or charge more to older people, or some combination of the above. The same thing is happening in non-group markets. Pretty soon, the only people who can get insurance are the ones who don't need it -- and/or people with health problems or who are over 50 can't get work.

Next: The half-assed solutions we have now, and the real answer.

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