Adverse selection in insurance markets: an exaggerated threat.

• Author: Siegelman, Peter

INTRODUCTION

The phrase "adverse selection" was originally coined by insurers to describe the process by which insureds utilize private knowledge of their own riskiness when deciding to buy or forgo insurance. (1) If A knows he will die tomorrow (but his insurer does not), life insurance that is priced to reflect the average risk of death in the population as a whole will look like a very good deal to him. Conversely, if B knows she will live for much longer than the average person with her observable characteristics (age, gender, medical condition), insurance that is priced to reflect the average risk of death will seem like a bad deal to her, and she will be unlikely to buy it. When A buys lots of insurance and B buys none, insurers find themselves charging an average rate to a population that contains only the worst risks, and end up losing money by virtue of having their product selected only by high-risk individuals. (2)

But informational asymmetry may not just be bad for insurers. When insurers cannot distinguish between good and bad risks, theory predicts that it is possible (although not necessary) to end up with no coverage for anyone: As the good risks begin to exit, the average quality of those insureds remaining falls and prices rise in a vicious circle, ending in a so-called "death spiral" where no one is covered. (3) Even when insurance is available, it may be inefficiently distorted by the presence of adverse selection. Many theoretical models conclude that when adverse selection is a problem, good risks will be rationed: They will be allowed to purchase only limited coverage in an attempt to make such coverage less attractive to the bad risks, who would otherwise be eager to purchase it given its favorable price. (4)

As we will see, courts, policymakers, and legal academics routinely--and often uncritically--discuss adverse selection as a major issue in the design and regulation of insurance markets. In addition, economists have devoted scores of articles to the subject over the last decade. But the thesis of this Essay is that although theory demonstrates that adverse selection can occur, and some instances have certainly been documented, neither the theoretical models nor the empirical studies provide much support for its widespread importance in insurance markets. The nature of selection pressures turns out to he vastly more complicated than the rhetoric of courts and academic commentators would suggest. And while the economic theory of adverse selection in insurance markets has become enormously sophisticated, much of it is devoted to ratified analysis of the nature and existence of equilibria. It has thus managed to obscure some essential features of insurance demand that may undercut or even reverse the typical adverse selection results. In short, while adverse selection in insurance markets is clearly a possibility, it is often not the serious problem that it is taken to be. Courts, policymakers, and legal academics need to do much more than trumpet a concern for adverse selection as a justification for their preferred course of action. (5) And economists need to develop less obscure and more realistic models, and pay more attention to the empirical issues (as indeed they are beginning to do).

This Essay is organized as follows. Part I describes the importance ascribed to adverse selection in insurance markets by courts, regulators, and legal commentators. The common theme of these actors' analyses is that adverse selection is an extremely significant problem--one that justifies deference to longstanding common law doctrines in tort and contracts and a hands-off attitude with regard to insurance regulation.

In Part II, I briefly explain the theory of adverse selection as developed in the economics literature, and discuss its implications for the behavior and efficiency of insurance markets. Economic models suggest that adverse selection can cause the outright collapse of insurance markets and will always produce rationing and various other forms of inefficiency. But while enormously sophisticated, these economic theories are, I suggest, ill-suited for the (often rather casual) reliance that is placed on them by courts and commentators.

Part III considers the assumptions and predictions of the adverse selection model and compares them with the existing empirical evidence. After some preliminary questions, I focus on three issues: First, can insureds actually outpredict their insurers, as adverse selection theory requires, and does this lead the worst risks to buy more insurance? Second, are adverse selection "death spirals" a serious real-world phenomenon? And third, are good risks typically rationed in the amount of insurance they can buy, as adverse selection theory predicts? I answer all three questions largely in the negative.

Part IV considers an alternative model of selection in insurance markets, in which it is the good risks who buy more insurance. The standard adverse selection models assume that insureds are homogenous except for differences in the probability of loss. In particular, everyone is assumed to be equally risk-averse, and there is therefore no relationship between an insured's risk aversion and her riskiness. Once the assumption of homogenous risk aversion is relaxed, however, alternative selection mechanisms become possible. I therefore discuss the theoretical and empirical support for a model of "propitious selection," (6) in which low-risk individuals are willing to buy insurance even at "unfair" rates. I conclude that propitious selection is at least as plausible as the standard adverse selection story in many cases.

1. ADVERSE SELECTION IN THE POLICY DISCOURSE

   It is rare to find a discussion of the functioning of insurance markets that does not mention concerns for adverse selection. George Priest, for example, has suggested that "[a]dverse selection is a problem central to every insurance context, and it dominates the insurance function." (7) In this Part, I briefly discuss some examples of how concerns for adverse selection have been deployed to trump other concerns that might inform policymaking or legal analysis. In some of these instances there may have been a legitimate concern that good risks would drop out of the insurance pool and that bad risks would remain in it, with unfavorable consequences. But appeals to adverse selection, often with relatively little factual support, are frequently an important--even decisive--factor in legal decisionmaking and in policy debates.

   1. Justifying Public Policy

      1. Civil Rights

         Consider the Equal Employment Opportunity Commission's (EEOC) guidelines for interpreting the Americans with Disabilities Act (ADA) in the context of employer-offered health insurance. The ADA prohibits discrimination on the basis of disability in any aspect of employment, which has been interpreted to include the provision of insurance benefits related to work. (8) This would ordinarily mean that an employer could not exclude persons with disabilities (such as AIDS or HIV infection) from coverage under its insurance plan. But the EEOC apparently had concerns that including high-cost/high-risk individuals (such as those with HIV) in a pool of low-cost/low-risk workers would raise the average premium so much that healthier individuals might decline to purchase insurance altogether, leading, in the extreme, to the destruction of the entire insurance pool. Hence, under the EEOC's guidelines, an employer can justify excluding persons with disabilities from insurance coverage if it can show that

         the challenged insurance practice or activity is necessary (i.e. that there is no nondisability-based change that could be made) to prevent the occurrence of an unacceptable change either in the coverage of the health insurance plan, or in the premiums charged for the health insurance plan. An "unacceptable" change is a drastic increase in premium payments ... that would [among other things] ... make the health insurance plan so unattractive as to result in significant adverse selection. (9) Of course, the practical impact of this exception depends on how stringently the EEOC and the courts apply the requirements it sets out. (10) For present purposes, however, what matters is that an agency otherwise committed to vigorous pursuit of a civil rights agenda has recognized that it might need to temper its goals because of adverse selection problems created by the equal treatment it would otherwise favor.

      2. Antitrust

         In the mid-1980s, a group of doctors and their HMO brought an antitrust claim against fee-for-service insurer Blue Cross & Blue Shield of Rhode Island. (11) Blue Cross & Blue Shield feared that it would lose younger, healthier customers to HMOs, which offered more comprehensive preventive health plans, leaving it with an older, frailer, and more costly pool of insureds. It therefore implemented a series of changes in its pricing policies and coverage to prevent the erosion of its customer base. Among these innovations was an "adverse selection policy," under which "employers were offered three different rates for Blue Cross & Blue Shield indemnity coverage," depending on whether they offered: (1) "only ... traditional Blue Cross & Blue Shield coverage" (the lowest rate); (2) "traditional Blue Cross & Blue Shield, a competing HMO and [Blue Cross & Blue Shield's HMO-substitute] HealthMate" (an intermediate rate); or (3) "traditional Blue Cross & Blue Shield and a competing HMO ... [without] HealthMate" (the highest rate). (12) This plan was designed to give employers an incentive to offer HealthMate and not to offer a rival HMO to their employees. Plaintiffs claimed that this behavior violated antitrust laws, because in many other contexts, offering a discount to dealers who agreed not to carry a rival's products would constitute a violation of the Sherman Act. (13) But in holding that there was no antitrust liability, the court reasoned...