Wednesday, February 17, 2010

When Demand of Healthy Consumers Falls, Insurance Prices Rise

Insurance markets are, in important respects, not like markets for other goods. The Indianapolis Star reports (here) on a legislative hearing about recent insurance rate hikes as high as 30% in Indiana. In testimony during that hearing, Robert Hillman, the President of Wellpoint in Indiana, explained that a big part of the increase was due "more healthy members leaving the insurance pools, leaving behind sicker members with higher costs." 

In most markets for most goods, when quantity demanded declines, prices fall. This can also be true for health insurance, but we must be careful not to conflate quantity demanded with the number of insurance consumers. A reduction in the numbered in insured does not necessarily mean a reduction in quantity of health care demanded. In fact, healthy consumers by definition do not impose substantial costs on insurance companies because they do not demand much in the way of health care. Sicker patients, by contrast, impose costs in excess of the premia they pay for insurance. So, when healthy consumers cancel insurance to avoid paying premia for services they do not use, that leaves only the sicker patients to pay, which causes average costs and consequently premia to skyrocket. In the economics literature, this is known as the problem of "adverse selection," and it is the main reason why so many proponents of health-care reform, including President Obama, favor mandatory participation by all Americans, so as to spread the risks and the costs of providing health insurance more broadly.

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