Overseeing and Preventing Adverse Selection

States try to assure that the health insurance market does not separate healthier individuals into some plans and sicker individuals into other plans, a process known as “adverse selection.” When adverse selection does occur, premiums for plans with a disproportionate number of unhealthy enrollees may go into a “death spiral,” becoming ever more expensive as healthier people go elsewhere for insurance. States attempt to control adverse selection by overseeing plans’ marketing practices and by prohibiting insurers from increasing the premiums they charge to individual policyholders or from moving policyholders into different plans when they become sick, a practice known as re-underwriting.

Example: In Florida, an insurer reportedly moved individuals from one block of business to another and then raised their premiums by as much as 200 percent when they tried to renew their policies. In 2002, the Florida Department of Financial Services suspended the company’s license.¹

Florida now prohibits the following:

To further guard against adverse selection and encourage plans to accept groups and individuals with all levels of health care needs, some states have established “reinsurance pools” that assist insurers in paying claims for the highest-cost enrollees. In these situations, an insurance carrier pays an assessment (sometimes the state also contributes) to a reinsurance carrier, who pays any of the insurer’s claims that exceed a certain dollar threshold. Thirty states either allow insurers to voluntarily participate in a reinsurance pool or require that they participate in a reinsurance pool. The states that do not use reinsurance are as follows: Alabama, Arkansas, Georgia, Hawaii, Illinois, Kentucky, Louisiana, Michigan, Mississippi, Missouri, Montana, Nevada, New Mexico, Pennsylvania, South Dakota, Virginia, Washington, West Virginia, and Wisconsin.²

Example: In the Idaho Small Employer Health Reinsurance Program, in 2006, insurers are responsible for the first $13,000 in claims for each worker that they reinsure. Under the “standard” plan that small employers most commonly purchase, for the next $87,000 in claims, the insurer pays 10 percent, and the reinsurer pays the remaining 90 percent. The level of reinsurance coverage may be changed at the recommendation of the program’s Board to reflect increases in costs and utilization within the standard market in Idaho. Insurers pay premiums to the reinsurance carrier and, in addition, all small-group insurers can be assessed a fee if the premiums fall short of actual reinsurance expenditures.³

Example: The Healthy New York program uses reinsurance to make coverage more affordable to employers of low-wage and middle-wage workers and more affordable to low-income individuals who purchase insurance on their own. Employers of low- and middle-wage workers, sole proprietors, and low-wage individuals can buy coverage through participating HMOs. The HMOs are responsible for the first $5,000 of each enrollee’s claims. After that, the HMOs pay 10 percent of claims, and the reinsurer pays 90 percent of claims, up to $75,000 for any enrollee in a calendar year. The state itself pays for the reinsurance.4

¹See Florida Department of Financial Services, “Gallagher Orders United Wisconsin to Stop Doing Business for Unfair Underwriting Practices” (Tallahassee: Florida Department of Financial Services press release, July 25, 2002, available online at http://www.fldfs.com/pressoffice/ViewMediaRelease.asp?ID=1243).

²Laudcino, op cit.

³Personal correspondence with Joan Krosch, Health Care Policy Program Specialist, Idaho Department of Insurance, August 4, 2006.

Optional Health Insurance in the UK and the US

Why, would anybody purchase additional optional private insurance, when free health care is available? “In the UK, everyone is entitled to free treatment under the public sector. However, the losses borne in case of illness are quite large because waiting times are long for hospital stays, for elective surgery, and for consultation with a specialist.” In the UK, there are three ways to acquire private insurance: 44% pay directly for it, 12% have the insurance deducted from their wages, and 44% receive it from their employer as a fringe benefit.

The group paying for private insurance was compared to the group receiving it as a fringe benefit. Their probability of hospitalization was .021 higher (compared with an average probability of hospitalization of .064), after adjusting for occupation, education, demographic variables, and the scope of insurance coverage. Thus, it appears that those that select private insurance, as compared with those that are given it, are more likely to require hospitalization: this is adverse selection.

Similar experiences are found in the U.S. The Federal Employer Health Benefit Plan (FEHBP) covers federal employees. For a number of years, a “high option” Blue Cross coverage plan was offered in addition to the “standard option.” The high option provided for slightly lower deductibles and fewer restrictions. By 2001, the high option premium was $1500/year higher than the standard option, reflecting the increased risk of the group that selected it. In 2002, the high option was dropped from the plan.

The potential size of the adverse selection problem can be appreciated by the fact that the top 10% of the population (ordered by health care expenditures) account for 70% of total U.S. health care expenditures, while the lowest 50% account for only 3% of total expenditures.

Sources: Pau Olivella and Marcos Vera-Hernandez. 2006. “Testing for Adverse Selection into Private Medical Insurance.” The Institute for Fiscal Studies, WP 06/02; Linda J. Blumberg, “Addressing Adverse Selection in Private Health Insurance Markets,” statement before the Joint Economic Committee, Congress of the United States, September 22, 2004.

Reserve Price Auctions on EBay

On August 30, 1999, EBay declared that they would be charging sellers $1 for “reserve-price auctions”. Sellers would still be allowed to set an undisclosed minimum price below which they would not sell an item. EBay also said they would require sellers to setup opening bids at 25% of the unspecified reserve auction price. Sellers are using reserve auctions to protect themselves from an unreasonably low final bid offer. Recent changes, modified the fee for reserve price items under $25, from $1 to 50 cents per listing. EBay is trying to satisfy both buyer and seller. Several sellers on EBay have complained concerning the increasing fees, but don’t expect them to go away, because EBay’s daily auction transactions are almost $7 million a day, roughly 40 times that of its nearest competitors.

Source: “EBay Customers Pressure Auctioneer To Change Plans for Charge, Bidding” By Scott Thurm. Wall Street Journal. (Eastern edition). New York, N.Y.: Aug 24, 1999. pg. B.9

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Resolving Information Asymmetries in Markets: The Role of Certified Management Programs

According to Harvard Business School Professor Michael W. Toffel in the article "Resolving Information Asymmetries in Markets: The Role of Certified Management Programs" Published November 3, 2006:

Hundreds of thousands of firms rely on voluntary management programs to signal superior management practices to interested buyers, regulators, and local communities. Such programs typically address difficult-to-observe management attributes such as quality practices, environmental management, and human rights issues. The absence of performance standards and, in most cases, verification requirements has led critics to dismiss voluntary management programs as marketing gimmicks or "greenwash."

http://hbswk.hbs.edu/item/5550.html

The above article explores what is needed for a voluntary signaling program (in this case environmental management program-ISO 14001 Environmental Management System Standard)in difficult-to-observe businesses.

He finds that a voluntary oversight program must have rigorous and preferrably independant verification and that adding a program substantially bolsters the credibility the business to its customers.

Hedging Salmon Prices in Alaska

In July of 1986 the price of West Texas Intermediate Crude was $11.58 a barrel (www.economagic.com). During this same period, the statewide average of Alaskan sockeye salmon was $.99 a pound while Copper River sockeye was as high as $1.40 a pound. Given an average red salmon can weigh 8 lbs., one fish was worth nearly the same as barrel of oil. Of course this is not the case today, when in fact the statewide average price of sockeye salmon is closer to $.74 per pound.

While there is certainly no comparison between the price of fish and the price of crude, one could argue the business of oil extraction and the business of fishing are risky due to fluctuating cycles, demand, supply and politics to name a few.

In the example of Southwest Airlines hedging a large percentage of its fuel requirements to purchase bulk fuel when, in 2005, the going rate of oil was $26/barrel. This saved Southwest $900 million.

A similar concept could hold water for a fish buyer. Especially if there is a situation when demand may be on the rise given world populations, global warming trends, and growing problems for the farmed salmon industry therefore increasing demand for wild salmon.

Risk adverse buyers who have done some forecasting homework might offer a higher than average price for multiple years, say $.85/pound for three years (high compared to the statewide average of $.74). If the trend is increased demand of sockeye, fisherman may lock in at that price if it means an up front increase per pound.

Sources: Alaska Department of Fish and Game; Png, I & Lehman, D. (2007). Managerial Economics. Massachusetts: Blackwell Publishing. p. 378

An Interesting Link - Insider Information and Asymmetric Information

The article below looks at asymmetric information in the form of insider trading and takes a position that had insider information been shared in the cases of Enron and WorldCom that the market would have found out before the companies collapse. Quite an intersting twist.

Insider Trading and Asymmetric Information

by Walter Williams (July 15, 2003)

Some of us know more about some things than others, and we often exploit that advantage.

I know more about my driving habits than my auto insurance company. Borrowers know more about their repayment prospects than lenders. The seller of a car knows more about the condition of his car than the buyer. Members of a corporation's board of directors and officers know more about the profitability of the firm than shareholders.

These are just a few among thousands of examples of what economists call asymmetric information -- one side of a transaction knowing more than the other. Should actions taken, and advantages achieved, on the basis of asymmetric (insider) information be made illegal?

Here's a case in point. Martha Stewart, CEO of Martha Stewart Living Omnimedia Co., has been charged with obstructing an investigation into insider trading. She hasn't been charged with illegal insider trading, but she did sell 3,928 shares of stock in the biopharmaceutical company ImClone Systems, earning $228,000, the day before the FDA rejected approval of its anti-cancer drug Erbitux and its stock fell. The Justice Department alleges that she received an unlawful tip from her stockbroker.

U.S. Circuit Judge Richard Posner defines insider trading as: "the practice by which a manager or other insider uses material information not yet disclosed to other shareholders or the outside world to make profits by trading in the firm's stock." One might agree that an officer of a company has a fiduciary duty not to give outsiders confidential company information so they can profit (or avoid losses), but let's look at insider trading as a general phenomenon. What does it do or not do?

The instant the FDA rejected approval of Erbitux, the true asset value of ImClone Systems fell. While the insider might profit from selling on the heels of that knowledge, one thing for certain is that insider trading rapidly gets information to the equity market about ImClone's true value.

You might ask, "Is this fair?" Whether it's fair or not, it's the nature of markets that people benefit from specialized knowledge. I might know that there's oil on your land and you don't, and I buy it from you for a pittance and earn millions. Is that fair?

Take the Enron and WorldCom cases. Long before their collapse, there were insiders who knew about the accounting fraud and other management sharp practices that inflated the worth of the companies. Had just a few of Enron's and WorldCom's many insiders, who knew of these practices, sold their shares or gave out well-placed tips, shareholders would have learned much earlier about the true value of the companies and might have been better able to protect themselves.

What's referred to as "the market" is simply a collection of millions, perhaps billions, of independent decision-makers. No economist believes that markets are perfect, like heaven or a utopia. But the relevant comparisons are to the alternatives that we have on Earth. When there's market allocation, mistakes and shenanigans are detected and ruthlessly punished. After all, it wasn't the Securities and Exchange Commission, whose charter is to protect investors, who discovered Enron's and WorldCom's misdeeds, punished them by making their stock worthless and made heads roll. It was the market.

What happens when Congress cooks the books by concealing expenditures, uses sleight-of-hand with the Social Security account to boast of a balanced budget and tells us federal liabilities are $6 trillion when in fact they're really closer to $35 trillion? What happens when Congress exempts itself from any semblance of Generally Accepted Accounting Practices (GAAP), which it imposes on the business community? Absolutely nothing happens.

As for me, I'll take the profit-driven motives of market participants any day over the do-good-driven motives of government officials and their underlings.

Source: http://www.capmag.com/article.asp?ID=2951

Information Technology Solves Government Asymmetric Information Problems

SUNDAY, AUGUST 20, 2006

MATTHEW E. KAHN

The New York Times today reports how some cities have used aerial photos to mitigate asymmetries of information with regard to which home owners have improved their properties. Cities are now collecting more property tax revenue due to this change and homeowners have less scope to lie as they seek reductions in their property taxes.

A broader point can be made that government use of information technology has improved urban quality of life. Do London’s cameras deter crime? Major city GIS maps of crime “hot spots” help police deploy their resources. Road pricing has become a reality now that vehicles can easily pay without stopping for entering a congested zone.

Broadly distributed data bases on which restaurants violate public health codes in California have created a “day of shame” for restaurants with mice and garbage. Broadly distributed data bases on which public schools have high test scores encourages accountability as parents choose where to live and home prices reflect the differentials. Both examples highlight how information technology affect individual choice.

Key asymmetries of information remain. Consider the Internal Revenue Service. If Mr. Smith reports that he earned $100,000 in 2005, did he really earn $130,000? Is he under-reporting his income? The IRS conducts audits to scare people into telling the truth but it is unclear whether the expected punishments are large enough. Who knows how many billions in tax revenue the government does not collect because it can’t measure people’s income accurately. Could improvements in IT mitigate this problem?

In the private sector issues of asymmetric information have been well studied by economists interested in adverse selection. George Akerlof’s concerns about how market efficiency is affected if only people trying to sell “lemons” appear at the used car market and that only sick people try to buy health insurance would vanish if used car buyers could cheaply be informed by a vehicle mechanic about the used vehicle’s condition or if health insurance sellers could cheaply receive a doctor’s report on an insurance buyer’s health. In both of these examples, information technology could reduce the asymmetries of who knows what. In the case of the used car, the seller has private information about its quality. In the case of the health insurance, the buyer has private information about his own health levels. The concern is that only the sick will buy health insurance. Thank goodness for hypochondriacs such as Woody Allen. Their existence tends to mitigate concerns that only the sick will buy insurance and this will lead to insurance companies going bankrupt.