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About twice a year I end up writing a post screaming at people for not understanding what the term adverse selection means as it pertains to the health insurance market. I can almost understand if the popular press gets it wrong (not really, it is the job of real reporters to understand what they are writing), but I cannot tolerate it when Pulitzer Prize winning faculty members of Ivy League institutions cannot get it right. Maybe they do understand it but nonetheless wish to portray the issues in a different light. Here is the latest offense (my goal this year is to read 20 books written by “progressives” that have gotten good reviews and have the potential to alter the way I think, here is Book #2):

If the government leaves the health-insurance market to voluntary choice, the costs of administering coverage are sure to be higher for small groups and individuals than for big employers. Individual consumers and small businesses also lack the knowledge and purchasing leverage of a large firm. Not unreasonably, insurers worry that in individual and small-group markets, those who sign up for insurance are likely to be at risk of high health costs (a problem known as “adverse selection”). In a voluntary market, insurers have every incentive to avoid covering the sick and instead to cherry-pick the healthy from among the individuals and small groups that apply for coverage. But if they do so, millions of people will remain uninsured.

The bolded section is the origin of the offense. You might be thinking, “it sounds right.” And you’d be right. In that sentence, he partially summarizes what the adverse selection problem is – but it would have been nice to see more detail. In a situation when the individuals purchasing insurance know more about their own health status than the insurers, we have what is called an “asymmetric information” problem. In this case, we are likely to see insurers charging premiums to all comers that reflect the average health status of all customers – since they cannot determine which customers are healthy and which are sick. In this case, insurance is a bad deal for healthy individuals since their expected medical expenses over the course of their lifetimes will be lower than the present value of the premiums they will pay over their lives. Insurance would be a good deal for the sick. In this case the premiums they would be paying would be a fraction of the expected value of their lifetime medical expenses.

The problem, you see, arises not from the fact that we have markets per se, but from the fact that we have an information asymmetry. If health insurers knew as much about your health status as you did, then everyone would have insurance for things that are insurable (more on that below). In this case, insurers would charge different premiums to difference classes of customers – with the healthier patients paying lower premiums than sicker ones (I am simplifying). But our author above is claiming that health insurers know, at least closely enough, who is sick and who is healthy. In other words, the fundamental condition for adverse selection to be present has been violated – he says so. Now to be fair, he says, “has the incentive” he does not say “they can actually do this.” But read the rest of the book and you will see that I am being generous.

OK, so even being fair, our author is confused (to be fair) or outright disingenuous and misleading. Why would I say that? Well, I think that Starr would agree that private insurance companies want to make money. Let me ask a rhetorical question. Do you think before dropping people entirely they would try to figure out a way to make money from them? It is really bad policy that prevents insurers from charging different premiums to different people – and it was the Progressives who pushed for these policies. Remember what I said about situations like this? Only when premiums cannot be adjusted to account for the higher costs of actually covering people would dropping them become a desirable option.

Before continuing, let me interject a decent idea for a policy proposal that includes government. If folks are not willing to allow insurance companies to charge for the higher cost of insuring the unhealthy, a reasonable proposal would either be for the federal government to step in as a reinsurer, or to provide subsidies to the unhealthy to purchase insurance, or better yet for the government to fully insure the sick for their chronic conditions. Why? If the condition has been fully-insured, then when a “sick” customer approaches an insurance company, that pre-existing condition has already been “taken care of.”  I see objections from many angles here: first that we should just have a full-blown free market and if anything just provide cash grants to people who need them. I see them from also coming from the camp that says that when a person has one condition it probably correlates with other negative health outcomes, so that pre-existing conditions could never be fully insured away. Note that the ObamaCare law tries to get at some of this issue. OK, back to the post.

If health insurers are cherry-picking health customers, that is the opposite of adverse selection. Starr seems to know this, but he could have been clearer. But onto the main point of the post. I cannot tell you how many times I have had discussions with students, parents and acquaintances about insurance and have heard them comment something to the effect of, “insurance companies have no right to charge the sick more, or to drop coverage” and they defend things like Obamacare ostensibly because “everyone needs to pay into an insurance pool in order for it to work.” But that is not right. Insurance cannot work for things that are not insurable. More on that in a future post.

Typically when I emphasize this point people like at me like I am some kind of a moral beast and this would truly puzzle me, since there is no moral position in making this seemingly analytic point. But now I see what is going on. The rhetoric of redistribution has taken over. I sense that a good portion of people view health insurance (and medical treatment) not as insurance, but as another form of redistribution. How else would they reject my observation above? By their thinking, “everyone” should pay into insurance so that people who “need” more will have the funds while people who “need” less don’t need as much. But real insurance has nothing at all to do with redistribution. It is NOT meant to redistribute resources from low-risk people to high-risk people. That is a political question of redistribution. Insurance is a way to pool like risks and that is all. So how could people be so confused? Again I lay the blame at the feet of FDR and the New Deal legacy. “Social insurance” programs emanated in the second New Deal as part of a grand political strategy by FDR to win votes. It worked. But he was extremely anxious about giving Social Security the appearance of being redistributive (read Amity Shlaes’ great book to learn more about this episode). So what is clearly a program that redistributes income from current workers to older non-workers is repackaged as “insurance.” And I wholly believe that using the rhetoric of “social insurance” to characterize a set of clearly redistributive policies has changed the psychology of how Americans think of insurance. Hence the utter contempt with which I am held by people when I suggest that some people are uninsurable. According to the redistributive vision of the world, that concept simply cannot exist.

There’s much more to say, in particular on the implication of administrative costs and a few other doozies from his book. They’ll come in due time.

4 Responses to “The Rhetoric of Redistribution”

  1. Speedmaster says:

    Fantastic post, thanks. And you’ve nailed the redistributionist mantra. I blame 40+ years of govt schooling. Further, I am also tired of people calling what is really pre-paid consumption, “medical insurance.”

    If you’re guaranteed to do it, it’s not insurance.

  2. jb says:

    Dead on w-cow and speedmaster (especially the point about schools). Somehow I am still under the delusion that insurance was protection against losses that are 1. catastrophic in nature and 2. unpredicatable.

    Wintercow you ARE too generous, Starr simply gets it WRONG and is confused. His argument is simply invalid. The simple fact is that adverse selection is an information asymetry problem in which consumers have an overwhelming advantage versus firms that might insure them. But Starr somehow concludes that:

    “In a voluntary market, insurers have every incentive to avoid covering the sick and instead to cherry-pick the healthy from among the individuals… ”

    I am repeating you but you are correct, w-cow. He says that insurers have an incentive to cherry pick. True, but of course they cannot because they are ignorant regarding the health of potenial consumer/insureds. In fact , not only do they lack the informational advantage to be able to do so, they do not even operate in an “informationally neutral” market, in which consumers would be equally ignorant about their own health. The advantage is of course in the hands of consumers.

  3. Rod says:

    Ever since my forties, I was the person in the company whose responsibility it was to figure out how to maximize health insurance coverage and minimize premiums paid. Because every one of those companies employed people with health problems, invariably we had to resort to Blue Cross instead of making a private deal with Aetna or US Healthcare or whatever. We paid through the nose for that coverage, but everyone was covered for pre-existing conditions.

    Blue Cross has been this country’s substitute for socialized medicine. If you want coverage, you will not be denied. The only problem is the price.

    Now, in the future instead of denying coverage (we will all have a government ID card, which federal officials of any kind will be able to demand that we show it to them) we will have those death panels that will decide we only have a few years left, so why spend a lot on grandpa (I will be 67 in April, so this means me).

    If you’re going to cherry pick, do it before the blackbirds clean the cherries off the tree.

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