Adverse Selection is an economic term that often comes up in association with the health insurance debates. In economics, adverse selection is generally associated with one party having more information than the other. The idea is that when you go into a business like insuring people against health costs the people who want your services are generally the people you would want to avoid doing business with.
Say you have a used car dealership that sells two types of cars, high quality used cars and low quality used cars. The dealership has 50 high quality cars and 50 low quality cars. The value of a high quality used car is $10,000, while the value of a low quality used car is $1,000.
If the dealers know what the quality of the cars they are selling then there is no way that they will sell a high quality car for less than $10,000 but they will be willing to sell a low quality car for more than $1,000.
Now let us assume that the buyers know that the cars have two values, but they don’t know which cars are high quality and which are low quality. Because there is a 50% chance of buying a high quality car and a 50% chance of buying a low quality car the buyer will get a predicted value of $5,500. But furthermore, lets assume that the buyer knows that no dealer will sell a high quality car for less than $10,000 so there is a 100% chance that if the buyer gets a car for $5,500 it will only be worth $1,000. So the predicted value of the car is now $1,000 and high quality cars are not sold.
Insurance operates in a similar way. Just think of the insurance company having imperfect information this time. The person who is buying health insurance knows what their expenditure on health care is, it is the insurance company who has to guess an average.
The insurance company prices their premiums at the average expected cost for the people who will be insured, but that means that only people who have costs over the average will purchase insurance coverage. Would you be interested in paying $1,000 a year for health insurance when your average yearly cost is only $500? This means that the total cost for the insurance company will always be more than its revenue; even if it continuously increases its insurance premium.
Health insurance that comes as a benefit through your employer cancels out adverse selection, for the most part. The insurance company gets a large number of people to insure in one group, there are high risk and low risk people in the group so the insurance premiums are lower than they would be individually. Another reason why people get health insurance through their employers is because the cost comes out of before tax income. So they can get $400 of health insurance for $350.
Keep that in mind the next time some one tells you that all out our health care woes are caused by the greedy insurance companies.
-m-
