Health Insurance – Part 2
Eric Jacobson
Key Definitions

Adverse selection – Enrollees may seek to
join a health plan at a premium that reflects a
lower level of risk than their own.

Risk selection – Occurs when insurers
attempt to attract more favorable risk group.

Moral hazard – Any change in individual
behavior due to insurance that increases
expected losses, such as higher utilization of
covered services. (Seat belts, Lipitor, low
copayments)
Adverse Selection

Sicker individuals more likely to:
• Demand insurance
• Demand more generous insurance,
given a choice of plans


Largely due to “asymmetric info”
(individuals vs insurers).
This process, called adverse
selection (or self-selection),
complicates the issue of how much
choice to offer consumers in the
health care market.
Consequence of Adverse Selection and
Community Rating:


Persons with poorer-than-average
health status apply for, or continue,
insurance coverage to a greater
extent than do persons with average
or better health expectations.
Experience Rating?
An Example of Adverse Selection
100 People
1 Person
30% chance of needing
$100k treatment
Pure Premium = ?
1% chance of needing
$100k treatment
Pure Premium = $1,000
(asymmetric info)
Adverse effects of adverse selection
Start with a community-rated, self-pay health
plan

Community of four with insurance premium
= $3000
Person “A” with E(B) = $600
“B”
E(B) = $2000
“C”E(B) = $4000
“D”
E(B) = $6000

Marginal analysis: E(B) vs E(C)




Decision of healthier enrollees “A” and “B”?
Avg. cost per enrollee increases.
Premiums increase => “C” drops out.
…and this can create a “killer price spiral”
Severe adverse selection can set in motion price spirals
that theoretically can cripple or destroy insurance
markets.
Key Definitions



Adverse selection
Risk selection
Moral hazard – Any change in individual
behavior due to insurance that increases
expected losses, such as higher utilization of
covered services. (Seat belts, Lipitor, low
copayments)
Moral Hazard and Demand
P
PF
DWL
CPF
D
QU
Q1
Q
What Should Be Covered?
Balance among (at least) three
theoretical considerations:



Risk aversion
Limiting moral hazards
Encouraging preventive care
Patterns of Insurance Coverage
Type of Health
Care
Variance of
Financial
Risk*
( L-I-R)
Demand
Elasticity
(R-HIE)
% of People
Under 65
Insured
Hospital Care
Highest
-0.15
80
Surgical & inhosp medical
High
-0.15
78
Medium
-0.3
40-50
Low
-0.4
40
Outpatient
doctor
Dental
The losses that are insured are: large*, infrequent*, random*, and not
associated with a large moral hazard.
Possible Solutions to the
Adverse Selection Problem?




Waiting periods
Preexisting condition exclusions
Experience rating (underwriting)
Insurance that precludes individual
selection according to subscribers’
perceptions of their own risk (Universal
health insurance, employment-based
insurance)
Possible Solutions to the Risk
Selection Problem?

Risk adjusted premiums
Possible Solutions to the Moral
Hazard Problem?





(Higher) co-payments
(Higher) deductibles
Medical savings accounts – similar to 401(k)
plans
Utilization review and case management
Since size of moral hazard problems (DWL)
increases with price elasticity of demand, offer
less generous insurance for specific services with
more elastic demand (e.g., mental health
coverage).