How to Think About: Health Insurance and Adverse Selection

Michael Kinsley on the complexity of insuring people with preexisting conditions

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(These articles are intended to help you to think through issues in the news about which you may be undecided. We tell you how to think about it. We try to leave what to think about it up to you.)

Insurance companies have been unfairly vilified for refusing to insure people with preexisting conditions, or charging them far more than other customers. In Las Vegas terms, health insurance is a bet against the house. You are betting that you will get sick and run up large medical bills. The insurance companies are betting that you won't. It is a bet you should be happy to lose, but still. For the insurers, a customer with a preexisting condition is a surefire losing bet. It's like selling fire insurance to someone whose home is already in flames.

Nevertheless, one health care reform that nearly everyone claims to favor is ending insurance company discrimination against people with preexisting conditions. Or, on similar logic, dropping people when they get sick. Even the insurance industry was ready to accept this principle when the current health care debate began, for fear of something worse (from their point of view). But is it possible to design a health care system with any room at all for private insurance companies that bans discrimination against people with preexisting conditions?

As supporters of Obamacare point out, such a system can’t work unless everybody is required to carry health insurance. With everyone in the pool, profits from the healthy customers will make up for losses on the sicker ones. If insurance is voluntary, people will wait until they get sick to sign up. What’s more, even if you could prevent people from gaming the system in this way, the problem would still remain. As long as insurance is optional, healthy people will be more inclined to go without than people who are sick or likely to get sick. This sets off a so-called "death spiral." If the average person in the insurance "pool" has higher health care costs than the average person who’s not in the pool, the cost of insurance will be higher than the average cost of going without. As a result, more healthy people will choose to go without, leaving fewer and sicker people in the pool, forcing the cost of insurance to be higher still, leading more people to drop out, and so on.

This process is called adverse selection and it’s one of the basic concepts of the insurance business and the health care reform debate. So Obama supporters are legitimately frustrated when polls show that people favor banning discrimination against preexisting conditions, but oppose any requirement that everybody carry health insurance. And they're right to be annoyed at health care opponents who pretend that we can have one without the other.

However, requiring everybody to carry insurance does not solve the problem. Even if health insurance is mandatory, adverse selection will continue to exist, along with the death spiral, as long as people have more than one option. (And giving people a variety of options is one of the touted benefits of reform.) Even if the differences between plans start out small, adverse selection will cause them to grow. People expecting larger medical bills will sign up for the more lavish plans while people with no expectation of higher-than-average bills will choose the cheaper ones. The lavish plans will have to raise their prices--not because they are more generous, but just because their average customer is sicker. Meanwhile the less costly plans will be able to lower their prices--not because they are more efficient, but because their average customer is healthier. The process will continue until only the least costly and generous plan survives.

There is no simple way to fix this. You can have a "bad risk pool" where the more costly customers are sent, funded by some combination of the insurance companies and the government. You can analyze the customer bases of different insurance companies, or plans, and redistribute profits among them in order to neutralize the effect of adverse selection. Either one is a formidable challenge, either one involves the government more deeply in health care than ever before, which everybody claims not to want. And either one is liable to end up with a "single payer."

If this analysis is right, opponents of Obama’s health care reform may have a point when they argue that it is a step down the slippery slope toward a single-payer health care system. But the same would be true of any other reform worthy of the name.

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This article is from the archive of our partner The Wire.