Tuesday, November 10, 2009

On Adverse Selection, Moral Hazard, and ObamaCare

Most of the attention associated with the Pelosi-Obama bill, which barely passed the House Saturday night after much arm twisting by Democrats, has focused on the astronomical debt the plan will add to the nations already dire fiscal condition. The Democrat Party will only admit to approximately $1 trillion in costs but the far more credible Heritage Foundation estimates the actual cost at about $2.6 trillion over 10 years.

In addition to the staggering cost, other prominent criticisms of the Pelosi-Obama government takeover of health care include the rationing of health care to the elderly (death panels), rapidly rising insurance premiums for all Americans, the basic premise that government should be in the insurance business at all, as well as many other issues too numerous to list. The Wall Street Journal has referred to this bill as perhaps the worst to be contemplated by Congress since the infamous Smoot-Hawley tariff of 1930.

One of the worst components found in all of the various health care bills, which collectively can be called ObamaCare, is the provision which prevents insurance companies from denying, or even rating, the coverage to those with so-called "pre-existing" conditions ("rating" is the practice of charging higher premiums or lowering benefits to account for enhanced risks discovered during the underwriting process). The criticism of this aspect of ObamaCare has been muted in most quarters with precious few exceptions.

The government takeover of health care has obviously been a topic of discussion on many of the various talk shows on both network and broadcast television of late. In watching many of these debates, I've been struck by the inability of ObamaCare opponents to effectively defend the very reasonable practice of denying or rating coverage based on pre-existing conditions. Indeed many so-called conservatives get uncomfortable when this is brought up and attempt to change the subject.

This is unfortunate. This practice is rooted in sound economic theory and is rather easy to explain to anyone with a rudimentary understanding of the concept of risk. Insurance, whether life insurance, auto insurance, homeowner's insurance, or health insurance, is based entirely on risk. In its simplest terms, insurance is nothing more than a form of risk management. The person or entity purchasing the insurance, the insured, is transferring the risk of loss to the insurer. In effect, the insured is assuming a smaller but known risk (the cost of the premium) to guard against an unknown but potentially much larger risk. In order for this arrangement to work properly, the insurer must be able to determine the risk of loss and charge a premium commensurate with that risk. Both the insurer and the insured have the right to manage their respective risk.

If private insurers are not allowed to make their own risk assessment based on all available information, including information relating to pre-existing conditions, the entire risk management process necessary to the survival of the insurance industry will be undermined, perhaps catastrophically. If insurance companies are unable to take the financial risk into account associated with such risk factors as family history, claims history, or pre-existing conditions through the underwriting process, they will be unable to properly indemnify themselves and in short order, given their razor-thin profit margins, will be at risk of bankruptcy.

Denying insurance companies the right to appropriately underwrite the medical insurance they issue will result in a situation where only those who are at imminent risk of needing medical coverage will purchase insurance. Those who are healthy will simply forego the insurance, confident that they can wait until they are sick to purchase the coverage. This is what economists refer to as adverse or negative selection.

This is not complicated. Why would a healthy individual purchase an insurance policy when he knows the insurance company must provide him with coverage by law, even if he waits until he's sick? There is no financial incentive for him to so. The $750 fine is far cheaper than the cost of coverage. Those who do purchase insurance will see their premiums rise dramatically as healthy people opt to pay the fine rather than purchase the insurance. This will leave insurers with a smaller pool of increasingly unhealthy policyholders. Insurers will be forced to raise premiums for these people to cover the increased costs, resulting in more people opting out, resulting in still higher premiums and so on.

This downward spiral is how the Pelosi-Obama bill will eventually bankrupt and eliminate the private insurance market. When opponents of ObamaCare make the point that the Democrat plan will drive private insurers out of business, this is the primary basis for that claim. Make no mistake; the goal of ObamaCare is to destroy the private insurance market which will ultimately result in a single-payer government monopoly in which health care will be doled out by the government for political rather than medical reasons. This has always been Obama's goal.

In addition to adverse selection, the risk of moral hazard will be elevated by ObamaCare. Moral hazard is closely related to adverse selection and is what economists refer to as the tendency to modify behavior in such a way as to assume more risks due to the presence of some form of insurance. For example, if a homeowner has fire (homeowner's) insurance, he may be more likely to place one of those dangerous kerosene heaters in his house on a cold day whereas he'd think twice about this if he had no insurance.

This same concept can be applied to health (or any other) insurance. If insurance companies are no longer able to properly underwrite health insurance policies, many people may decide to eat cheaper and less healthy food, exercise less, take up smoking, etc. Again, insurance companies will be required by ObamaCare to provide them coverage regardless of the lifestyle decisions they make. The incentive to maintain a healthy lifestyle in order to save on health care expenses will have been removed from consideration by government decree. Obviously, saving on health care costs is not the only reason to stay healthy, but is undoubtedly a factor for some. Economics teaches us that people do respond to incentives, despite what Democrats claim to believe.

Nancy Pelosi, in a breathtaking display of ignorance, claimed that when insurance companies take pre-existing conditions into account, they are engaging in some form of "discrimination" and that such a practice is "scandalous". The only thing that's scandalous is that someone so astoundingly obtuse is Speaker of the House. Moral hazard and adverse selection are two exceedingly simple concepts that any first year economics student understands better than, apparently, most of the Democrat Party from Obama on down. An accurate assessment of risk exposure is crucial to the economic viability of any insurance company, regardless of what they're insuring.

Governor Palin herself dealt with these issues in an October 17 Facebook Note more effectively and succinctly than I've heard any opponent of ObamaCare address it on television (on the rare occasion they deigned to address it at all):

The bill prohibits insurance companies from refusing coverage to people with pre-existing conditions and from charging sick people higher premiums. [1] It attempts to offset the costs this will impose on insurance companies by requiring everyone to purchase coverage, which in theory would expand the pool of paying policy holders.

However, the maximum fine for those who refuse to purchase health insurance is $750. [2] Even factoring in government subsidies, the cost of purchasing a plan is much more than $750. The result: many people, especially the young and healthy, will simply not buy coverage, choosing to pay the fine instead. They’ll wait until they’re sick to buy health insurance, confident in the knowledge that insurance companies can’t deny them coverage. Such a scenario is a perfect storm for increasing the cost of health care and creating an unsustainable mandate program.

Once again Governor Palin demonstrates an understanding of economics which dwarfs that of Obama and those who support ObamaCare. Adverse selection will be nothing less than the undoing of the private insurance market. There can be no doubt that, were she in charge, we wouldn't even be discussing the concept of the U.S. health care system being run by the same people who run the post office.

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