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Posted: May 12, 2011

The Economist: What is adverse selection—and do I really care?

Tucker Hart Adams

Almost 25 years ago, I was invited to join the board of a big property and casualty insurance company, my first public company board. I learned a lot in my years on the board.

I learned that a director has a Duty of Care and a Duty of Loyalty; that it is possible to insure deadbeat drivers and golf tournaments and sand and gravel trucks, if you understand the business; that there are law firms that file frivolous (my judgment) lawsuits on "behalf" of shareholders because they know the company will settle out-of-court, and they can split the settlement.

I have a vivid memory of the latter. Another board on which I served had been sued and a group of us was being deposed, including the shareholder who had filed the suit - an old geezer from a small town somewhere in the Midwest.

"Mr. Jones, was X Company unfair to its shareholders?" the attorney asked.
"Oh, no, no, I wouldn't say that. X was a fine company."
"But they took advantage of you and cut your dividends. Isn't that true?"
"No, I wouldn't say that. They paid dividends every quarter, just like clockwork. Made me a lot of money."
"Mr. Jones, are you telling me that you don't believe X Company took advantage of you and other shareholders?"
"Nope, never did. They're a fine company."
"Well then, Mr. Jones, why have you filed this lawsuit against X Company?"
"Why, because some lawyer from New York City called me and told me I'd make a lot of money if I did so."

But, I digress.

One thing the insurance company board spent a lot of time on was a seemingly endless discussion of adverse selection, one of the two bogeymen of the insurance industry. (The other is moral hazard - when a party insulated from risk behaves differently from one not insulated from that risk.) Adverse selection is a fairly simple concept. It refers to the proclivity of those with higher risk to purchase more insurance than those with lower risk.

Before my insurance company board experience, I wondered why my mortgage company required me to purchase flood insurance. I live at 7,000 feet, on a hilltop that our real estate agent told us is the highest point between the Rockies and the Appalachians. If I need flood insurance, the rest of you better start building an ark. But, of course, the requirement is a way to avoid adverse selection - requiring only people in flood plains to purchase the insurance would make it prohibitively expensive.

Adverse selection is very relevant to the high cost of health insurance in the U.S. and the recent legislation often referred to as Obamacare. Insurance companies worry that the only people who will buy health insurance are those who are unhealthy. The elderly and those with chronic diseases will purchase insurance, then file big claims. It's perhaps the primary reason that individual policies are so expensive.

Young, healthy individuals will opt to "go bare" (another insurance company term). I wrote a couple of years ago about my conversations with young people at my grandson's wedding, who don't purchase health insurance because "we don't get sick." The pending challenge to Obama's health insurance legislation, which claims requiring people to purchase health insurance is unconstitutional, is very troubling. I don't see any way to have affordable health insurance if those who are young and healthy can opt out, waiting until they are older and sicker to purchase insurance.

There are no simple answers to the adverse selection problem, other than insisting that everyone purchase the insurance. It's why I had to buy flood insurance when I bought my house. It's why I have to have auto insurance to license my car. And, it's why the solution to health care must require all of us, healthy or not, to purchase health insurance.
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Tucker Hart Adams, president of the Adams Group, monitored and analyzed the Colorado economy for 30 years. She can be reached via her website, coloradoeconomy.com.

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Readers Respond

Interesting topic. Adverse Selection was one of the key factors in the recent change to the health care reform law to repeal free choice vouchers. Interesting article on that here http://www.staffscapes.com/site/comments/761/ By Angelo on 2011 05 20
Zachary, Both Kaiser Permanente and Rocky Mountain Health Plans are not-for-profit providers. If that is the perfect model why hasn't everyone flocked to these two companies? My insurance carrier is a for profit company and charges less than either of these two. Car insurance is required by law yet we have thousands of drivers that do not carry insurance or sign up long enough just to renew their registration if they even do that. That's why there's the option for uninsured motorist coverage. How would health care would be any different. Also, auto insurance is based on your driving record, yet I would guess that you would not want your insurance premium to be based on your health history. Regarding the other government services you listed, I guess we all do benefit so long as you ignore the debts and deficits. We do all get sick and we all still die. Health care hasn't changed that fact regardless of the system. By John Gimple on 2011 05 19
Insurance works as a gamble on the part of the consumer that something bad will happen and they'll need it and on the part of the insurer that they won't need it. This works for things like auto insurance where not everyone will get into an accident. The odds are you won't and therefore the company can profit. What's interesting is that everyone with a car is required to have insurance and as such it keeps premiums down because those that buy insurance but never need it pay for the high costs of accidents for other folks. And yet I don't hear your shrill protests about government intrusion there. The difference with health care is that everyone gets sick and everyone dies. There is no gamble. It's guaranteed that the consumer will have to pull funds back out of the system. Therefore insurance companies have a motivation to reduce benefits and pay outs. Simple fact. This is why a for profit model in health insurance is absurd. It's a fundamentally flawed system. A successful non-profit can pay a reasonable wage to people who do the work and not pay dividends to stock holders or have to worry about year over year profit increases. Money coming in goes to administration and service, that's all. As a summary point we all pay for eachother's needs in a society. It's part of being in a community. If you'd prefer to live in an anarchic state I'm sure there there are plenty of options out there that would accommodate your preference. We all pay for roads, postal service, police, fire, social security, the national defense, open spaces, libraries, schools, etc... What's wrong with that? We all benefit from a more educated society, we all benefit from a lawful society, we all benefit from a nationally mobile and accessible society. Why would we not all benefit from a healthy society? By Zachary on 2011 05 19
Zachary, If health care is not completely run by government, then you still have a for profit system. You say "Under a single payer system the care would be more accessible, due to mandate, and more economical, due to 100% buy-in." A one payer system does nothing for cost control, especially when that control goes to Washington. You say access will go up. Not necessarily and if it does, that usage will increase costs. Mandates increase costs. 100% buy-in? Really? There is no 100% buy-in! The lower income will continue to not pay for insurance because the costs will be forced upon taxpayers and businesses. Whether health care is run by for profit business or government cost control has to be a consideration. Look at other one-payer systems. Canada rations services. There is no endless pot of money for health care. There does need to be costs control and more individual responsibility. I keep hearing people say that once you get sick the health insurance carriers drop your coverage, but in 50 years I have never met someone who's coverage got dropped because they came down with a disease. On the other hand, I do see health care companies taking advantage of the system. As a recent example, my doctor recommended I have a colonoscopy because of my age. I asked if that was done under a local or general anesthesia. My doctor told me the company does not even offer the procedure with a local anymore because insurance is willing to pay more to have it done under general anesthesia. He also said the the change is not because of safety. General anesthesia carries more risks. I don't care if the law originated as a republican or democrat plan. The law is heavily flawed and will not control costs. I actually did read the one of the last versions of the bill before it became law. Did you? By John Gimple on 2011 05 19
John, First off let' avoid the hyperbole. No one said the insurance companies are evil. That would imply malevolent intent. They simply are corporations out to make a profit. That's fine in most cases but there are certain aspects of society where profit motive has a negative effect. Secondly the government would not need to take control of actual medical care. That was quite the Orwellian leap you made there. Care is rationed by insurance companies and income currently. Under a single payer system the care would be more accessible, due to mandate, and more economical, due to 100% buy-in. Best we could have hoped for given overall conditions was a public option. Unfortunately Republican obstructionism and weak tactics by the administration killed that option quickly. Thirdly Obamacare as you derisively refer to it is actually 1990s Republican-Care or Dole-Care if you will. Look it up. I am not here to get into the flawed negotiation tactics of the Obama administration, in that they start negotiating in the middle and therefore have no where to go but right. Finally I am fully aware that the Affordable Care Act is a flawed piece of legislation. And I agree that a large part of what it does is funnel more funds to insurance companies. This is unfortunately an example of just piling on top of the horrendously flawed system we already have. At least this way however there are mandates for coverage and if you have mandates for coverage in a for-profit system you need mandates for participation. By Zachary on 2011 05 18
Zachary, For your model to have a chance, the government would have to be in complete control of all medical staff, hospitals, and pharmaceutical companies and be able to dictate who will be paid what and when. Plus they would also have to dictate what care and how much you received. That is not the law. Obamacare does not get rid of your evil health insurance corporations. It just guarantees an even bigger revenue stream. The liberal approach always seems to be more money will solve all out problems. If the insurance companies are to blame, it is for not negotiating better fees with the health care providers. Their annual profit is typically in the 3 to 5% range. Hardly exorbitant. The fees charged by the health care providers is what is out of control. You are right about one thing. The mega corporations have too much control over our government's actions. With that in mind, how do think the situation will actually change? By John Gimple on 2011 05 18
Rick and John, It's always interesting when people have cognitive dissonance. You somehow hold two contradictory ideas in your head at once. It's amazing. Why should health care be rationed by for profit companies rather than by a government we at least in theory have some input into? Would you rather have someone provide you with "insurance" whose only motive is squeezing every last cent out of you while providing as little in return as possible or a government bureaucrat whose motivation is to simply process your paperwork, cut a check, and move on to the next one? You have this incredibly naive idea that companies have your best interest at heart. Companies only have profit at heart because that's what they do. You are right in once sense that companies naturally streamline themselves in order to be more competitive and more profitable. This of course means that they will naturally take your money until you get sick and then drop you. They have nothing but motive to do that. So what if you're not their customer anymore? You are now on your own to be a drain on some other stockholder's portfolio. You are no longer a profit center for them. The market has spoken, you can now die in a gutter of a curable disease. The only time you might be able to avoid this is if you have millions of shares and can affect the board. Or you can collectively purchase insurance through a company or a government or a co-op. Then there are enough eggs in the basket that they'll hang on to you so they can keep getting money from everyone else in the pool. With our government their motivation is to, at least in theory, respond to and take care of their constituents. Unfortunately we have allowed corporations to be treated like people in this arena so yes our voice gets crowded out, but only because people who think like you allow this to happen by defending corporations over your own rights and interests. Reagan was very effective at one thing. He re-branded "our government" as "the government" and gave you an enemy to fight while they fleeced your rights and interests and gave them to corporations. The government is "our government" so long as we remember that the soldiers are our neighbors and are our government, that the postal worker or the DMV employee, or the congressman are citizens just like us and if we exercise our right to speech before it's completely drowned out by corporations; then we still have our government. By Zachary on 2011 05 18
Thank you Rick! By John Gimple on 2011 05 18
My goodness Kent and "Events"... have we forgotten why companies offered insurance to employees? It was offered as an inducement to work for THAT company. A recruiting tool for those creative souls that chose to take the risk. A perk to create a superior workforce that supported his/her idea in creating a better product or service. A COMPETITIVE edge! An inducement to potential employees to "decide" to go to work for that company (or as a BENEFIT to stay, as well as profit sharing, company match retirement plans, etc). When did we assume that it was the duty of a company to provide an employee with health plans? When government said so? This debacle is all part of a few generations of "entitlement" mentality. And a shoutout from those affected by the catistrophic costs of disease treatments. How many generations back in your family tree were they even discussing this? Seriously, there are only a few civilized countries that this applies to. Is this the dialogue they have in Iran? NO! Do European countries going broke come to mind? We are blessed to live here and to have this dialogue or debate. I do not except or want my President or Congress to mandate my participation or yours on my behalf. NO! I want creative license to resolve this and less government management of my day to day life. Our government track record stinks and Congress is a cesspool! Seriously. And if you think government is the answer.. I fear for our future. I will never trust a politician to make a better decision for me than me. Period. I am a veteran and have put it out there to protect my right to voice my opinion and to hear yours. Take charge and quit whinning! Let's find a better way to help those in need. Governments do not create wealth.. they take from some to give to others.. and pocket the rest! It is not an infinte resource! Companies owe us nothing. Companies are evil when politicians allow it. Vote! By Rick B on 2011 05 18
Why can't more people think like you do, Tucker? People who say they were rasied to be responsible, and raised their kids to be, can get multi-million dollar illnesses and be turned away by their insurance companies and end up in the same circumstance they are so critical of others being in. Living in society means taking care of yourself and helping others. Insurance for all takes care of us all. By Events Submit on 2011 05 17
Kent, Please explain why you believe it is the responsibility of companies to provide insurance. I believe companies should have the freedom to decide on providing health insurance. Many do while others prefer to provide higher wages and allow the employee to make the choice. The costs of the uninsured is already reflected in premiums whether paid by a company or individual. Under Obamacare, the tax penalty isn't enough to deter the uninsured, and the low-income and unemployed will continue to subsidized/paid-for health care by the tax payer and insurance companies. By John Gimple on 2011 05 13
A voice of sanity. People without insurance who do get sick often beome dependant on public health care. Through a convaluted system the insured pay higher costs to support the uninsured. Put us all on a level playing field. Employeers who do the right thing and provide insurance have to compete with companies that leave their employees uninsured. Why give an advantage to those who shed responsibilities while leaving it to the tax payer to care for their uninsured emplyees. Further, hiding behind the constitution is intelectual blindness. By Kent Stringer on 2011 05 13
David Ess, you are 100% right. Insurance is something you get in case something happens. Not everyone will get in a car accident or have their house burn down so there is a calculated risk involved and a company can make a profit off of it. Health care is something that everyone will need at some point, there is no getting around it. I keep hearing, from some, that the affordable care act will hurt business and the economy. There are some major flaws to that argument. 1) If I have a pre-existing condition and my insurability is dependent on being employed then I can not go and create my own business no matter how great my idea is. 2) If my insurance is dependent on my employer then I can not quit if being mis-treated 3) If my insurance is dependent on my employer and I get laid of through no fault of my own (maybe like 10% of the population in 2008) why do I get to die of a curable disease? We are part of a society and as such we are obligated to participate in the general welfare. If you don't want to contribute then this is not the society for you. By Zachary on 2011 05 12
Sorry Ms. Adams if you were snookered into buying flood insurance when you didn't live in a flood plain. Let's call the current state of health care what it really is: Racketeering and Extortion. Unfortunately, Obamacare will not correct the problem. If you read the law, costs are shifted to businesses and individuals with the ability to pay. Lower income families are subsidized, so that portion falls on the taxpayers. Making healthy individuals buy insurance only adds to the pool of money and does not control costs. By John Gimple on 2011 05 12
Wow, since when is it our responsiblity to pay for everyone who does not want insurance???? I raised my children to be responsible adults, why not other parents and children? Being a business owner, why is it my responsiblity to "force" people to buy insurance when they do not want it. I know for a fact that some of my employees don't think they need it (and it is offered EVERY year)so they opt out. That is their choice. Why should the government mandate they buy, if it is not wanted. Get real! This is a true story of Robin Hood, have Obama take from the rich (or not so) and give to those who don't care, but expect! By linda on 2011 05 12
Ms Tucker Hart.. I can not disagree with you more! Thank you Rick A, Dick M and Jawaid. Well Dorothy.. I hope that you are not relying on our well managed and fiscally efficient government to take care of you. Worse yet is that you and Ms. Tucker Hart seem to think that it is quite right for others to pay your way. We are on a road to fiscal disaster with this administration and Congress and their entitlement mentality. Some of us have our sunglasses on and enjoying the ride down this road. Sad that any of us can mentally justify this. By Rick B on 2011 05 12
Flood Insurance protects a homeowner from a possible but not necessarily likely scenario. It protects you from financial ruin in case of the unpredictable. - Injury and sickness are guaranteed. The need for healthcare is guaranteed at some point in your life. - I think we need to make a semantic shift at some point in order to ever reach a consensus, and that means re-naming the product in a way that reflects what it actually does now. It is now pre-paid health care, no matter what it started as. By David Ess on 2011 05 12
Tucker, met you many years ago,when a friend named Adams formerly of Denver US National Bank introduced us. You seemed sane at that time. Now we must use "reductio ad absurdem" logic to educate the "DR." Insurance is all about "Risk," and the spreading of a risk over a wide range of folks. Mortality and Morbidity tables record human experiencewith death and illness. You can't provide life insurance for a dead man, nor can you provide cancer insuracne for a man dying of cancer. The alternative is called a gift, a benefit, or government subsidy. Nor can you force a man to buy insurance under our much maligned and often ignored onstitution. Your fellow 'dismal scientist', John Stuart Mill, compared what you suggest, forcing the public to buy something; with a loss of freedom. QED. By Jack Flobeck on 2011 05 12
No, the reason everyone must be forced to purchase insurance is that it's good for insurance company bottom lines. Isn't that right? If only every business could use government compulsion, threat of fines and imprisonment, to FORCE everyone to purchase their product. Why there would be no more problems of any kind, ever! By Jawaid Bazyar on 2011 05 12
Dr. Adams, You are missing one point and incorrect on another. The tiny fine for people not buying insurance does little to avoid the problem caused by adverse selection. Fine me $600/year till I get sick, then I'll buy insurance. The second issue is that driving is a choice. I bicycle, therefore, I don't buy car insurance. By Dick M on 2011 05 12
The important question is whether the federal government forcing individual citizens to purchase a good/service is constitutional...not whether it's a good idea or not. I would hope a person of Ms. Tucker Hart's intellect would see there's a clear differences between her flood insurance example and the health insurance mandate. If she didn't want to buy flood insurance, there were plenty of other insurance companies she could have done business with. The issue is constitutionality, nothing else and that's what the debate should focus on at this point...not opinions as to whether it's a good idea. By Rick A on 2011 05 12
Tucker, As usual, you hit the nail on the head! Thank you for your insight. By Dorothy A Walch on 2011 05 12

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