The insurance-market death spiral makes sense in theory, but economists do not really know if, and how often, it is a practical consideration in real-world health insurance markets.
Adverse selection refers to a failure of buyers and sellers to transact because one or the other has additional information about the quality or cost of the product to be traded. A classic example from the 2001 Nobel laureate George Akerlof is the market for quality used automobiles, which in theory cannot exist, because buyers of used cars demand a heavy discount because of the likelihood that a used car they might buy will be defective. In theory, nobody sells a quality used car, because it would have to be priced like a lemon.
The used car market is, in theory, caught in a kind of self-fulfilling prophecy in which only defective cars are traded in the marketplace and are priced accordingly.
The same phenomenon has been used to describe the health insurance market. In theory, absent government intervention, only sick people will buy health insurance, which means that insurers have to charge a lot for the insurance, which means that healthy customers will not buy insurance. This is the supposed “death spiral” for health insurance markets.
The solution to this purported problem is to force everyone – especially the healthy – to buy health insurance. That starts a domino effect of other problems, including the unfortunate side effects of the redistribution, such as discouraging employers from creating and employees from accepting full-time jobs, which authors of the Affordable Care Act found to be necessary in order for everyone to be able to comply with the mandate to buy insurance.
I agree with the 2001 Nobel committee, which explained that the adverse selection idea is “a simple but profound and universal idea, with numerous implications and widespread applications.” Still, we don’t really know if the side effects of proposed market interventions are more tolerable than the disease itself.
The used automobile market is a good example. A prudent car buyer should be aware that defective cars are out there.
Nonetheless, the market for used cars did not experience a death spiral and today is active and vibrant. Without any government mandate that the owners of quality used cars sell them, the marketplace has devised a number of practices, such as cars leased from the manufacturer, manufacturer warranties and fleet resales, that help buyers expect quality used cars and thereby prevent the death spiral.
Economic theory predicts that all consumers buy actuarially fair insurance – that is, insurance in which each buyer expects to receive as much as he pays – so the mere fact that many people do not have health insurance (especially healthy people, who do not buy because it is too expensive) would seem to prove that the health insurance market is failing.
But the fact is that health insurance companies, like just about any business, have significant capital and labor overhead costs. Insurance premium revenue is needed to pay those costs. Under such conditions, the average consumer must expect to receive less than he pays. Many healthy people may thereby be uninsured for a good reason: the overhead costs are too much to justify whatever feeling of safety that insurance might give them.
The market might be selecting participants in a productive way. Forcing the insured to buy insurance may be a waste of society’s resources by adding to the already significant overhead costs.
Without proof that adverse selection outweighs other kinds of selection in health insurance, the death spiral may not be a serious threat, and government actions to prevent it may be unnecessary.