Adverse Selection: The Next Generation

Although  a “death spiral” sounds more like the subject of a Star Trek episode than a description of an insurance market, several states in the past 20 years have experienced catastrophic collapses of their health insurance markets that would have left Captain Kirk reeling. A report issued earlier this year by America’s Health Insurance Plans (AHIP) describes the rise and fall of community rating and guaranteed issue policies that have left the health insurance markets in shambles.

Community rating is a policy that controls the price of premiums for individuals with high-risk medical conditions. Usually an insurer would charge very high premiums to individuals that are most likely to get sick. Community rating prevents this practice, and the policy has  usually been accompanied by a guaranteed issue provision that prevents insurers from denying these individuals coverage. The intent is to expand affordable care to all individuals, but a basic economic theory called adverse selection warns that these policies quickly lead to a train wreck, or what in formal economic literature is called the death spiral.

The spiral starts when high-risk individuals take advantage of their new low-price premium options. Insurers are then forced to raise the average premium in order to maintain enough revenue to cover their expensive medical procedures. As rates go up, healthy individuals will decide to drop their coverage, since they don’t expect to need as much care as they are paying for. As the low-risk group drops out, premiums increase again, and the next lowest-risk group drops out. Premiums increase again, and the worm-hole sensation starts to set in.

The AHIP report confirms that the death spiral is a real thing. Seven out of the eight states that enacted the policy did not see any significant decrease in the uninsured population, and most saw premiums increase substantially. Kentucky and Maine were two of the states that experienced very serious collapses in insurance markets, with many firms exiting the market altogether. Massachusetts is the only state that has actually increased insurance coverage because of the laws. This was only accomplished with the use of an individual mandate, which is currently under review by the Supreme Court as part of PPACA, and may be ruled unconstitutional.

The upshot is that insurance markets are fragile, and regulatory policies can quickly upset the natural balance of things. If we want to expand coverage, then innovative policies need to be tested that will prevent the death cycle, improve care, and allow the markets to live long and prosper.