Adverse Selection in the Health Insurance Industry - Essay Example

Adverse Selection in the Health Insurance Industry Introduction It is irrefutable that all the industries in the economy face specific risks, whichdirectly contribute to the profitability and attractiveness of the sector. These risks, in turn are brought about by inevitable forces that compels businesses to devise strategic actions and moves to offset their negative externalities. One such risk is brought about by information asymmetry. Information asymmetry occurs because of imperfect information in the market. Imperfect information, in turn, occurs because some information are not fully disclosed in the market making some players more informed than others. Information asymmetry causes two problems that are identified as moral hazard and adverse selection. While moral hazard is the risk faced after the transaction has occurred, adverse selection happens when due to asymmetric information between buyers and sellers: "'bad products or customers are more likely to be selected (Adverse Selection 2005).'" This paper will discuss adverse selection in the health insurance industry. It will first explore the concept of information asymmetry and then apply this concept in the health insurance market. Afterwards, it will suggest possible ways in combating problems within the industry. It will then wrap up with its findings. Adverse Selection Adverse selection was first noted by the American economist George Arthur Akerlof in 1970. This phenomenon is also coined as the lemon problem and arises from the inability of traders and buyers to differentiate or make a right judgment on the quality of products they are purchasing (Akerlof 1970). To illustrate this concept, the market for second-hand cars is always often exemplified. Naturally, the seller of a used car has more information about the car he is selling than any buyer in the market. The asymmetry of information can be used by the seller for his own advantage. As he is perfectly informed and any buyer is not, he will likely utilize the information that he needs to sell the car at a good price. If his car is a "lemon" (poor quality car), he can still profit for it as the customer lacks the information that he possesses. Akerlof provides three components on the theory of adverse selection: first, "there is a random variation in product quality in the market;" there exists an asymmetry of information on product quality; and there is a greater willingness for poor quality car seller to trade at low prices than higher-quality owners (Akerlof 1970). In the market for used cars, it is inevitable to find poor quality cars among good quality ones. Logically, sellers are fully informed about the true value and quality of the used car. As stated above, the seller usually holds important information, which should be revealed to both parties. Imperfect information will erode the competitive advantage of the seller, giving the customer an opportunity to make more reasonable judgment and valuation to the car being sold. The third component also makes sense as sellers of poor quality used car are also always willing to sell their goods at lower prices since they know how much their car is really worth. Typical sellers always see to it that buyers purchase their products at a price that is higher of equal to the true value of their products. Rationally, they can afford to sell their products at lower prices as long as it can cover the true worth of their poor quality car. Adverse Selection in the Health Insurance Industry Adverse selection is one of the most common problem faced players in the health insurance industry. In fact, the adverse selection phenomenon is a major theoretical dilemma in health insurance markets, which leads to considerable market inefficiencies (Cutler 1997). Adverse selection occurs in the insurance market as those who individuals who prefer more generous and expensive insurance plans are those who are more likely to require health benefits. Logically, when an individual expects to suffer more health problems, he aggressively searches for coverage of the expenses that he will incur. He will opt for insurance with higher premiums with the expectation of higher returns during the time of his sickness. Meanwhile, those who are facing moderate health risks are not likely to seek for insurance coverage as they do not expect to incur expenses associated with their health. Adverse selection occurs in the health insurance market as the information on the real health situation of a customer is not fully revealed to the insurer who cannot ascertain the true value of insurance coverage for an individual. Adverse selection happens when unusually high risks individuals select an insurance plan or when individual with expected costs higher than the population average sign up for an insurance policy. We can further illustrate this with a numerical example. For example, a person with expected costs of $30,000 sign up for a health insurance policy with $10,000 policy. This is adverse selection as the expected benefit is greater than the costs. This situation will lead to significant profit losses for the insurer since he is paying more than what he initially anticipates. A health insurance company's main task is to ascertain and estimate risk. After identifying the amount of risk involved in servicing a customer, they price this risk and pass it down to the insured. However, when adverse selection happens, there is an evident failure in the part of insurance companies. When an insurance company realizes that it is losing money due to under valuation of risks, he raises the premium paid by the people insured. After the premium is raised, however, the higher premium causes relatively lower risk people to drop the policy, which in turn pushes up the average costs incurred by those remaining. Since those who remain are those who are likely to be requiring higher premiums, the company will start to loss more money and raise the premium again to cover its expenses. However, this will cause lower risks individuals to drop out. This continuous cycle is also known as Premium Death Spiral, which shakes the lower costs individual to drop out and continues until only those individuals with the higher health risks remain (Adverse Selection and Cream Skimming 2002). Adverse selection is not only detrimental to insurance companies but also adversely affects consumers who opt to purchase an insurance policy. Since adverse selection pushes the price of insurance in order to take into account the high risk posed by "above-average" risk individuals, consumers with moderate health risk are more unlikely to get a health insurance at fair prices (Adverse Selection and Cream Skimming 2002). Cutler (1997) has identified three classes of inefficiencies caused by adverse selection. First, adverse selection in health insurance causes "prices in the top participants will not reflect marginal costs, hence on a cost and benefit basis individuals will select the wrong health plans." Second, "desirable risk spreading is lost." Lastly, "health plans will manipulate their offerings to deter the sick and attract the healthy." These inefficiencies will always lead to market failure as the industry is hindered from realizing its main function in the society. Solutions to Adverse Selection Since adverse selection contributes to market efficiency and is detrimental to both the insurer and insured. It is therefore, imperative to find solutions to combat this phenomenon. One logical way of reducing adverse selection in the insurance market is by letting players get more accurate information (Adverse Selection and Cream Skimming 2002). This considerably reduces the information asymmetry, as insurers are more informed about each individual's health risk. Another way of reducing adverse selection is by lifting restrictions on how premiums are set. However, these two alternatives will consequently drive up the premium paid by chronically ill and high-risk people. Another setback of this alternative is the high price of acquiring information about prospective clients. As high-risk individuals are more likely to conceal details that would deter them in acquiring them an insurance policy, the insurer will have to spend significant amount of time and money to fully gain a complete and fair assessment of an individual's health. Put simply, additional information will require huge investment for insurers. Adverse selection can also be diminished by restricting consumer choice. This can be done by offering only one set of insurance plan for a group or by mandating that everyone purchase a given plan. This is especially applicable to business entities that are purchasing packages for their entire workforce (Adverse Selection 2005). As there is a higher probability of getting healthier people in the work place thereby reducing the risk of acquiring more cost than the benefits. Lastly, it was also suggested that adverse selection could be eradicated by restricting the timing of consumer choice. This can be done by establishing waiting periods before someone can purchase insurance in order to fully assess the health situation of an individual planning to acquire coverage. Pre-existing conditions can also be excluded. Conclusion Adverse selection in the health insurance industry is a consequence of information asymmetry. Since the insured is typically more informed about his health situation than the insurer, the insured can often make use of this information for his advantage. Adverse selection happens when the expected cost for an insurer is higher than the benefits from the premium payments. As individuals with higher health risks opt for more expensive and generous insurance package, insurers often loss money. This phenomenon can also lead to Premium Death Spiral, which is detrimental to both insurer and insured. To eliminate or reduce adverse selection in the health insurance market, possible solutions are given such as acquiring more information, waiting periods, and restricting consumer choice. However, these solutions also entail setbacks. It is therefore imperative for companies and policy makers to design solutions, which are beneficial and executable in the long run. Reference List Adverse Selection 2005. Retrieved Nov. 7, 2005 from http://en.wikipedia.org/wiki/Adverse_selection Adverse Selection and Cream Skimming 2004. Retrieved Nov. 7, 2005 from http://www.healthinsurance.info/ Akerlof, G, 1970. Adverse Selection. Retrieved Nov 7, 2005 from http://www.economyprofessor.com/economictheories/adverse-selection.php Cutler, D, Zeckhauser, J, 1997. Adverse Selection in Health Insurance. National Bureau of Economic Research Working Papers. Retrieved Nov. 7, 2005 from http://www.nber.org/papers/W6107 Read More