Thursday, June 28, 2012 – Adverse Selection, Asymmetric Information, Large Numbers, and Healthcare

Adverse Selection, Asymmetric Information, Large Numbers, and Healthcare 
– by Sinclair Noe


DOW – 24 = 12,602
SPX – 2 = 1329
NAS – 25 = 2849
10 YR YLD - .04 = 1.58%
OIL +.79 = 78.48
GOLD – 22.20 = 1553.00
SILV -.62 = 26.42
PLAT – 19.00 = 1396.00


If you had gone to Las Vegas and put down $5 dollars on Obamacare with John Roberts as the swing vote, your odds would have been about a million to one. According to Vegas bookmakers, nobody placed that bet; it was just too outrageous. This morning, a majority of the Supreme Court upheld the constitutionality of the Affordable Care Act, otherwise known as Obamacare. The big surprise, was the vote by the Chief Justice of the Court, John Roberts, to join with the Court’s four liberals.


On the crucial issue in the case – whether the “individual mandate” requiring almost all Americans to purchase health insurance was a constitutionally-permissible extension of federal power under the Commerce Clause of the Constitution – Roberts agreed with his conservative brethren that it was not. If that was the end of the decision, it would have killed Obamacare, instead, it just tripped up the reporters at CNN and Fox who were so intent on trying to deliver “breaking news” that they forgot to read before speaking.  Roberts upheld the law because, he reasoned, the penalty to be collected by the government for non-compliance with the law is the equivalent of a tax – and the federal government has the power to tax. What's in a name?


Roberts wrote for the court's 5-4 majority: The law's "requirement that certain individuals pay a financial penalty for not obtaining health insurance may reasonably be characterized as a tax." The Republicans actually introduced the idea of the individual mandate in the 1990's. Remember? Maybe Roberts recognized the irony and decided to give the GOP something to oppose – taxes.  Actually, the whole concept of insurance falls apart under the weight of adverse selection; more on that in a moment. 


Roberts was joined by justices Ginsburg, Breyer, Kagan and Sotomayor  and he wrote in the majority decision that in the end it did not matter whether the law called it a penalty. "That label cannot control whether the payment is a tax for purposes of the Constitution," he wrote. "Because the Constitution permits such a tax, it is not our role to forbid it, or to pass upon its wisdom or fairness," he wrote,.


The Supremes ruled that the penalty that must be paid if someone refuses to buy insurance is a form of tax that Congress can impose under its taxing power. That is, of course, good news for supporters of health care reform since a mandate, or something like it, is needed to stop health care markets from breaking down due to what is known as "adverse selection".


The intent of the mandate is to overcome this adverse selection problem. 


Adverse selection can be a problem when there is asymmetric information between the seller of insurance and the buyer; in particular, insurance will not be profitable when buyers have better information about their risk of claiming than does the seller. Asymmetric information means one party to a transaction knows more than the other party, and that gives the more informed party an advantage. When there is adverse selection, people who know they have a higher risk of claiming than the average of the group will buy the insurance, whereas those who have a below-average risk may decide it is too expensive to be worth buying.


Health insurance companies try to overcome this by demanding health histories, and by refusing insurance for pre-existing conditions, or just denying coverage when you get sick, or by charging older people more than young people. The young and healthy have knowledge they are young and healthy and so they demand a lower price for the most part; the breakdown starts when some people are willing to take a chance and go without insurance. With the relatively healthy people dropping out of the insurance pool, the price of insurance must go up, and when it does, more people drop out, the price goes up again, and this repeats until the market breaks down and insurance becomes unaffordable.


Insurance spreads out the cost over a wide pool of people; it is a redistribution of wealth, from the old and sick to the young and healthy; think of it as a tax on the young and healthy. Meanwhile, when the uninsured require health care it increases the costs of health care, it's like a tax on the old and sick that do pay for insurance. Under the current system, hospitals are required to treat patients who show up at the emergency entrance.  The hospitals have to pass the costs on, and the rest of us end up footing the bill.   


The universal mandate or tax is designed to fix that, by making everyone pay for the health care they get (and perhaps even encouraging them to see a doctor who will advise them to adopt a healthy life style). 


The bottom line is that the only way to get around adverse selection is to have full participation. You must rely on the laws of large numbers – this is the only way insurance can work; and whether you want to call it a mandate or a tax, everyone is going to need to participate and everyone is going to have to pay for it and receive benefits.


The alternative, the old way of doing things, involving adverse selection and asymmetrical information will eventually lead to a breakdown of the healthcare system; that was the path we were on. Obamacare is nowhere near a perfect solution but it was one attempt to address the problem (and something is better than nothing).  There will be revisions. And one thing we can count on with certainty, as I said yesterday, is there will be unintended consequences. For example, since money strapped states are not likely to expand Medicaid, another flukish part of today's ruling which means putting the law into effect will be tricky; the unintended consequences may result in failure or they may lead us to a better solution; the most likely outcome is that it will lead to universal health care. 


The United States is a holdout for universal care. In countries that have universal care, the cost is relatively low; less than 6% of GDP for Canada, France, the UK, Germany, Sweden, Denmark, and Taiwan for example. In the United States, the cost of healthcare is 18% of GDP – triple the cost of universal care. And what do all these countries with lower health care costs get for one-third the price? The have higher life expectancy rates and lower infant mortality rates and everyone has health care. 


Yeah, I know, you still don't want the government telling you that you have to pay for healthcare; you don't want anyone telling you that you have to pay for someone else's healthcare. That argument holds up until your wife or your kids get sick.