How Health Insurance Providers Make a Profit 5: Avoid Sick People
Posted by Chris Martin at 2/2/2008 3:07 PM 
Categories: Health Insurance, Adverse Selection, Market Failure
Categories: Health Insurance, Adverse Selection, Market Failure
In the past decade the simplest and most effective route to profit for Health Insurance Providers has been to avoid insuring sick people. Healthy people pay premiums and don't use costly services. The more healthy people an insurance provider can sell policies to, the lower costs and the higher the profit. This is easily said but it has become practical only with recent innovations in the health insurance industry.
Until just this decade most health insurance providers relied on clumsy and ineffective screening procedures, mainly long confusing questionnaires and cursory medical examinations, to detect and turn away sick people. These only caught the most obvious cases and are entirely ineffective in screening people who get their insurance from group plans.
Now Health Insurance Providers can rely on simple behavioral methods to direct unhealthy people toward policies offered by other health insurance providers. Here's the trick: Healthy people a generally quite naive about the ins and outs of health insurance and don't really care too much. They expect to be healthy forever. People who have been sick have learned what to look for in a health insurance plan and what to avoid. Specifically they will avoid plans that require large expenditures by the insured before the insurer begins to pay for care. Healthy people will snatch up these low quality health plans without a second thought.
What is happening here is the reverse of adverse selection as discussed in my post on health insurance pricing. Every time an insurer lowers the quality of her individual and group plans the insurer's pool of insured will become healthier. Her plans will cost less to administer for two reasons: Lower quality plans are cheaper to finance because they pay a smaller part of health care costs and it is always cheaper to insure healthy people.
Unless they follow suit, competitors will soon find that they are insuring the sick people who are being shed by plans that have adopted a low quality strategy. Their costs will increase and, if they raise rates to cover the added costs, more healthy people will abandon their plans. Even the most high minded, not for profit health insurance providers will be forced to follow the market leaders, if they want to stay in business.
Mother Teresa herself would not be able to resist this pressure. As far as Wonks Anonymous can tell this sort of creative destruction, will eventually lead to individual and group health insurance markets where all policies available will pay for health care only in the most catastrophic circumstances. These will not be cheap since insurers will recognize that people who are willing to buy such policies have a higher than normal probability of having medical catastrophes.
Wonks Anonymous believes that this is called market failure in the economics literature. He notes here that his problem with the health insurance industry is not the pursuit of profit per se but the direction that the pursuit of profit leads in this particular industry. That is, to an industry that sells an expensive and almost entirely useless product.
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