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Saturday, July 7, 2012

Adverse selection and the Obamacare Death Spiral

The death spiral built into Obamacare is the concept of adverse selection. It seems the law makers who jumped on board with President Obama overlooked a small inconvenience in their misunderstanding of this concept. Let’s take a look at adverse selection and how it impacts insurance providers:

The term adverse selection was originally used in insurance. It describes a situation where an individual's demand for insurance (either the propensity to buy insurance, or the quantity purchased, or both) is positively correlated with the individual's risk of loss (e.g. higher risks buy more insurance), and the insurer is unable to allow for this correlation in the price of insurance.[This may be because of private information known only to the individual (information asymmetry), or because of regulations or social norms which prevent the insurer from using certain categories of known information to set prices (e.g. the insurer may be prohibited from using information such as gender, ethnic origin, genetic test results, or preexisting medical conditions, the last of which amount to a 100% risk of the losses associated with the treatment of that condition). The latter scenario is sometimes referred to as 'regulatory adverse selection'

Furthermore, if there is a range of increasing risk categories in the population, the increase in the insurance price due to adverse selection may lead the lowest remaining risks to cancel or not renew their insurance. This leads to a further increase in price, and hence the lowest remaining risks cancel their insurance, leading to a further increase in price, and so on. Eventually this 'adverse selection spiral' might in theory lead to the collapse of the insurance market.

To counter the effects of adverse selection, insurers (to the extent that laws permit) ask a range of questions and may request medical or other reports on individuals who apply to buy insurance, so that the price quoted can be varied accordingly, and any unreasonably high or unpredictable risks rejected. This risk selection process is known as underwriting. In many countries, insurance law incorporates an 'utmost good faith' or uberrima fides doctrine which requires potential customers to answer any underwriting questions asked by the insurer fully and honestly; if they fail to do this, the insurer may later refuse to pay claims.

One reason why adverse selection may be muted in practice may be that insurers' underwriting is largely effective. Another possible reason is negative correlation between risk aversion (e.g., the willingness to purchase insurance) and risk level (estimated ex ante based on observation of the ex post occurrence rate of observed claims) in the population: If risk aversion is higher amongst lower risk customers, such that persons less likely to engage in risk-increasing behavior are more likely to engage in risk-decreasing behavior (i.e., to take affirmative steps to reduce risk), adverse selection can be reduced or even reversed, leading to 'propitious' or 'advantageous' selection

The mandate to purchase insurance will not offset the disadvantages to insurers of being forced to take on ALL pre-existing conditions. The pool of so called uninsurable will not be offset by the so-called reasonable risks who will have to pay exorbitantly higher premiums for their own coverage. This has never worked and the new law is simply mandating that insurers discontinue underwriting. Without underwriting there is no way to level premiums or factor future claims costs. It simply will lead to bankrupting the majority of health insurers. The WH contention that there will somehow be “affordable” insurance laughs considerably in the face of reason.

The reality is for any health insurance coverages to be enforced the premiums will have to become prohibitive. (I personally just received a 24% increase on my renewal from BC/BS, and I was claims free for the entire year and also have no adverse health history to speak of). These prohibitive premiums will be the direct correlation for healthy individuals to choose the penalty (not a tax according to Obama, only a tax according to SCOTUS) instead of the insurance premium. President Obama likes to say that Americans will be responsible and pay for insurance instead of the lower costs of the penalty. Yet the reality will rapidly become that healthy individuals will not want to pay exorbitant premiums for the adverse selection that is mandated by Obamacare. Yes Americans are responsible but they are also rational when it comes to their finances. Obamacare will bankrupt Health insurers and then it will bankrupt the US in totality.