Duke University Press
Mark V. Pauly and Sean Nicholson - Adverse Consequences of Adverse Selection - Journal of Health Politics, Policy and Law 24:5 Journal of Health Politics, Policy and Law 24.5 (1999) 921-930

Adverse Consequences of Adverse Selection

Mark Pauly and Sean Nicholson

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The turnabout in public opinion about managed care has been especially striking. In the space of only a few years, managed care went from being the centerpiece of many proposals for health reform to being the target of legislative action that forbids it the managerial actions that constitute its essence. What happened? Were the initial members of managed care plans overly accepting of restrictions they later discovered to be oppressive? Did plans change over time to become more aggressive? Or, is the controversy only political? We wish to suggest that there was more to the backlash than political mobilization of a few inevitable malcontents; rather, neither initial buyers nor original plans changed their views or behavior. Instead, a crucial part of the change, and a potential cause of the backlash, was a change in the kinds of people who were joining managed care plans. 1 The changes we will highlight are different from the kinds that can be easily brought into the policy analytical framework because they represent transfers among different sets of insured persons. The policy process must address the much more vexing question of who should gain and who should lose, with the total approximately constant. The source of this difficult problem, as with so many other problems in health insurance, is adverse selection. [End Page 921]

Adverse Selection in Insurance: Theory

There is an economic theory of adverse selection in health insurance, well known among economists in general, that so far has had few real-world applications. This theory was developed by Michael Rothschild and Joseph Stiglitz (1976) to explain how competitive insurance markets would behave in a world in which everyone knows that buyers differ by risk levels but insurers are unable to distinguish among risks. Rothschild and Stiglitz show that, if potential insurance purchasers know their risk levels (if they can keep that information from insurers) and if insurers are willing to offer any potentially profitable contracts, a process of sorting or self-selection can ensue.

This process works in stages. Assume that the market begins with a single policy offered. If insurers cannot distinguish well among risk levels, the premium for the policy will be approximately "community rated"; that is, it will be similar for all potential buyers. However, such a situation cannot be an equilibrium if insurers are free to enter and if consumers know which risk type they are. Since high-risk consumers value generous benefits more than do low-risk consumers, there will always exist another policy, less generous in effective coverage than the community-rated one, but lower in premium that will cause different risk levels to separate themselves. In the case of two risk classes, high and low, there will always be a policy that the low risks will prefer to the community-rated policy, while the high risks will prefer to stick with the old policy at the old premium. In the next stage, once that new policy is offered (and the low risks drain off), the old policy can no longer be profitably offered at its original premium; since it is now chosen only by high risks, its premium will have to rise. After the premium has increased, it is possible that the high risks will now prefer the new policy, with less generous coverage to the old community-rated policy; the original policy will disappear and everyone will move in yet another stage to the new, limited policy. As we will note below, however, even this third stage is not the end of the story. In fact, the Rothschild-Stiglitz model displays the intriguing if upsetting property that there may be no equilibrium; the market may move cyclically from one policy to another, never settling down.

Adverse Selection in Insurance: Application to Managed Care

Does this model help to explain what has been happening so far in many managed care markets? The first, or community-rated, stage seems to [End Page 922] correspond roughly to what insurance markets were like before managed care started to grow. Policies took the form of indemnity insurance and were similar in terms of coverage. Insurance offered on the open market to small- and medium-sized firms was only lightly experience rated. (Self-insurance practiced by large groups is obviously perfectly based on group experience.) Next, there is good evidence that oftentimes (though not necessarily always) managed care plans offered alongside the old comprehensive indemnity or "Blue Cross-type" plan tended to attract people who were low risks (Jackson-Beeck and Kleinman 1983; Luft 1981). The requirement of changing physicians, and the expectation of consumers that managed care coverage was better for people with mild illnesses who wished to avoid hospitals and heroic measures (as compared to people with more serious illnesses or those who preferred more aggressive treatment), often made managed care enrollments nonrandom, attracting disproportionate numbers of those who had been low utilizers in the indemnity plan.

These features would correspond to the first and second stages of the Rothschild-Stiglitz model, in which an initial policy that was purchased by both high and low risks at approximately pooled premiums set the stage for the low risks to be attracted to a new policy with less generous coverage but lower cost. Of course, analysts have always been wary of catastrophic indemnity insurance as an insurance attractive to low risks, whereas managed care coverage, with only minimal cost sharing, appeared to be more generous coverage than a moderate deductible Blue Cross policy. However, there is more to coverage than the extent of out-of-pocket payment. Coverage is also defined by the restrictiveness of use of care and the type of provider; on this score, managed care is definitely less generous.

It is the next stage of the Rothschild-Stiglitz model that we think is relevant to the managed care backlash. As lower risks were attracted away from conventional insurance, its breakeven premiums had to rise. Once that happened, there was yet another stage in which many of the higher risks decided to migrate to managed care. Our key insight is that the process of making this move literally was, for the higher risks, only making the best of a bad lot. They would have much preferred their initial situation with moderate premiums and permissive indemnity coverage, but the selection process destroyed that option; their only choice now was between a much more expensive indemnity plan and a lower-cost but more constraining managed care plan. No wonder that the high-risk consumers became upset, especially as it dawned on them more and more that managed care was not the kind of coverage they had been used to. [End Page 923]

There is yet another stage of the Rothschild-Stiglitz theory to be mentioned because it seems to describe what is happening right now in the world of transitions we are describing. Once the premium for the generous plan rose to the higher level and most of the market (including moderately high risks) had been pushed into more restrictive coverage, it would no longer be necessary for that type of insurance to be so restrictive. If there were few remaining high risks for restrictiveness to keep out, there was less need for limits on networks or access. So, in a paradoxical but understandable development, managed care recently became less restrictive in many markets, even as the volume of complaints about its restrictiveness grew. At the same time, indemnity insurance became more "managed." Networks expanded to cover the great majority of providers in a market, pretreatment approval requirements were relaxed, and external processes for settling disputes between insured and managed care plans were put in place by the plan. In effect, the market was returning to something very close to the original pooled plan. (Indeed, the out-of-network, point-of-service coverage now so popular in managed care plans does have cost-sharing provisions often almost identical to the old Blue Cross plans.)

There is, as befits a model with cycles, yet another stage of the Rothschild-Stiglitz model and one which may describe the health insurance market yet to come. But let us postpone that consideration in order to review the empirical evidence in support of the interpretation we have postulated.

Empirical Evidence in Support of the Model

IMAGE LINK= There is some convincing empirical evidence supporting the Rothschild-Stiglitz model. Figure 1 presents data on the percentage of employees at large firms who were enrolled in indemnity and managed care plans in 1984 through 1998. It seems reasonable to characterize the health insurance market in 1984 as a pooling equilibrium. Over 90 percent of employees had indemnity insurance, mostly with Blue Cross and Blue Shield, which experience rated only reluctantly. This pooling equilibrium unraveled between 1984 and the early 1990s when health maintenance organizations (HMOs) and preferred provider organizations (PPOs) quadrupled their share of the large employer market. By 1998, the original market shares had been almost exactly reversed; managed care plans collectively had an 86 percent share of the large-employer market and indemnity plans appeared to be in the final throes of a death spiral. [End Page 924]

IMAGE LINK= In the previous section we argue that HMOs initially picked off low-risk individuals who were least likely to object to restrictions on utilization of services and physician choice. If the difference between indemnity and managed care premiums had remained constant over time, presumably the average risk of each insurance type would have remained constant. Figure 2 displays the average annual percentage change in indemnity and HMO premiums between 1981 and 1998. Although the rates of change in premiums generally move in tandem, indemnity premiums grew substantially more than HMO premiums between 1986 and 1991. This pattern would be expected to occur as low risks shifted into managed care. As the opportunity cost of remaining in an indemnity plan increased, higher-risk people eventually switched, perhaps with apprehension, to managed care plans; after 1991 the growth rates became similar.

We argued above that once a sufficient number of high risks join managed care plans, the plans (and low-risk enrollees) would become less interested in maintaining the restrictions that were intended to keep the high-risk individuals out in the first place. There is strong support for this hypothesis. Information on the size of HMO provider networks is reported in Table 1. Between 1990 and 1997, the average number of hospitals per HMO plan doubled, and the average number of primary care physicians and specialists per HMO plan nearly tripled. Consumers are [End Page 925] clearly attracted to plans that combine broad choice with a low premium (relative to indemnity). Managed care plans that cover some portion of out-of-network care (PPO and POS plans) have increased their enrollment among large employers during the last two years while non-POS HMO market share has actually fallen (Figure 1).

While managed care plans were beginning to resemble indemnity plans by increasing the size of their provider panels, indemnity plans were adopting managed care techniques in an attempt to control costs, offer competitive premiums, and maintain market share. In 1993, 52 percent of the indemnity plans were requiring precertification for elective surgery (reported at the bottom of Figure 2. By 1996, almost three-quarters of indemnity plans were requiring such precertification. Perhaps we have come full circle; the health insurance market in 1998 could be characterized, once again, as an approximate pooling equilibrium (or at least an equilibrium with pooling of unobservable risk differentials). In the early 1980s people of different risk levels were enrolled, for the most part, in a similar type of indemnity plan; now people of different risk levels are enrolled, for the most part, in a similar lightly managed care plan. There do not appear to be big differences between types of managed care [End Page 926] plans. In 1997, for example, the average number of hospital days per thousand PPO and HMO enrollees was 252 and 231, respectively. Although a nonnegligible percentage of employees at large firms are still covered by an indemnity plan (14 percent), even these individuals are likely to have their care managed to some extent.

Implications of the Rothschild-Stiglitz Model for Citizen Dissatisfaction

If high- and low-risk individuals are currently pooled in managed care plans, the Rothschild-Stiglitz model suggests that they might both be dissatisfied. High-risk individuals who dislike utilization management and restrictions on physician choice might resent the restrictions associated with managed care and may be unhappy about indemnity premium increases. If these individuals joined a managed care plan recently, they will not appreciate that managed care plans have actually become less restrictive over time; their comparison will be to the indemnity plan they left because its premiums became unacceptably high. Low-risk individuals might also be dissatisfied with managed care because they are increasingly subsidizing high-risk individuals. As long as managed care premiums continue to rise slowly, however, the low-risk individuals will not realize the extent to which they are subsidizing the high risks.

Over thirty thousand individuals in sixty different markets were surveyed in 1996 as part of the Robert Wood Johnson Community Tracking Study. Table 2 presents data from this attitudinal survey of the HMO respondents toward health providers, their insurance company, and health care generally. Survey respondents were asked a series of twelve questions regarding their physical health and were assigned a score according to the SF-12 methodology (Ware, Kosinski, and Keller 1995). Individuals who were enrolled in an HMO at the time of the survey are assigned in Table 2 to one of three groups depending on whether their [End Page 927] SF-12 score is in the lowest quartile among this population, the middle two quartiles, or the top quartile. High-risk individuals are clearly less satisfied with their health plan. A relatively small percentage of individuals in the worst physical health are very satisfied with health care generally, their choice of primary care physicians and specialists, and the quality of the care they receive. High-risk individuals are also more likely to agree that their physician is influenced by HMO incentives and that their physician restricts access to specialists.

What Should Happen Next?

If this is an acceptable explanation of how the backlash came to be, what are the appropriate reactions from those concerned about public policy? Most people might be upset that the previous cross subsidization of high risks by low risks was disrupted. However, it is important to note that this disruption was only temporary. Now that the traditional Blue Cross plan has virtually disappeared as an option for the middle class, the different [End Page 928] risk levels again find themselves sharing a common insurance plan. A major difference is that other low risks and high risks do not like it as much as their old (but infeasible) plans. High risks find it more restrictive, and lower risks find it less of a bargain than their original, low-risk HMO. Despite our argument about the moderation of managed care aggressiveness, there are some differences in insurer behavior which are likely to persist forever with no turning back to the good old days unless regulators require it.

What are the messages for regulatory policy? Despite the bad feelings and the nostalgia, we suspect that few would want to go back to the old Blue Cross-type policy entirely. The notions of emphasis on preventive care (even when it is not so cost effective), and the idea that some insurer oversight of physician behavior is in the interest of consumer satisfaction, are probably here to stay.

What is more important in our view is for public policy to deal with the adverse selection cycle. One more insight from the Rothschild-Stiglitz model is that the somewhat more generous pooled policy that we currently seem to be moving toward in many markets will not be a permanent destination. Instead, once we arrive there, the original process of self-selection will start all over again. The Rothschild-Stiglitz model tells us what sort of thing to look for--some coverage provision that will appeal to the low risks but not pick off the higher risks. Low payments to providers leading to a "self-shrunken" network already appear to be one such device, though there will doubtless be others.

There is, however, an alternative to having policy makers try to guess what slick insurers (and greedy low risks) will come up with next as a cherry-picking device. Everyone could be made permanently better off, and the cycle avoided, if risk levels could be measured and adjusted for. That is, some type of risk adjustment could help low risks to retain the preventive-care-encouraging, inpatient-care-discouraging features of group- or staff-model managed care plans.

How such adjustments would work in private markets is far from clear. Employers or purchasing groups might decide to risk adjust the employer payment. Regulators might enforce transfers through high-risk pools or forbid coverage provisions targeted at lower risks. Tax policy makers might adjust the tax subsidy to be more generous to high risks. But at least we know one of the directions in which we should look.

University of Pennsylvania

Mark Pauly is the vice dean of the Wharton Doctoral Programs, Bendheim Professor and Chair of the Department of Health Care Systems at the Wharton School of the University of Pennsylvania. He is professor of health care systems, insurance, and risk management and public policy and management at the Wharton School and professor of economics in the School of Arts and Sciences at the University of Pennsylvania. His classic study on the economics of moral hazard was the first to point out how health insurance coverage may affect patients' use of medical services. His subsequent work has explored the impact of conventional insurance coverage on preventive care, on outpatient care, and on prescription drug use in managed care. In addition, he has explored the influences that determine whether insurance coverage is available and, through several cost effectiveness studies, the influence of use on health outcomes and cost. Pauly is an associate editor of the Journal of Health Economics and of the Journal of Risk and Uncertainty.

Sean Nicholson is assistant professor of health care systems at the Wharton School of the University of Pennsylvania. He received his Ph.D. in economics from the University of Wisconsin-Madison. He is currently involved in a research project to measure and examine the determinants of risk selection in employer-sponsored health insurance plans in sixty U.S. health care markets.

Note

1. We do not argue that this is the only source of backlash. Consumer misinformation and tax incentives to employers to choose insurance for their employees also contribute (Pauly and Berger 1998). Here we highlight a neglected reason.

References

Jackson-Beeck, Marilyn, and Joel Kleinman. 1983. Evidence for Self-Selection among Health Maintenance Organization Enrollees. Journal of the American Medical Association 250(November):2826-2829.

Luft, Harold S. 1981. Health Maintenance Organizations: Dimensions of Performance. New York: Wiley.

Pauly, Mark V., and Marc L. Berger. 1998. Why Should Managed Care and Managed Care Insurance Be Regulated? Paper presented at the Fifth Princeton Conference, March.

Rothschild, Michael, and Joseph Stiglitz. 1976. Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information. Quarterly Journal of Economics 90(November):630-649.

Ware, John E., Mark Kosinski, and Susan D. Keller. 1995. SF-12: How the Score the SF-12 Physical and Mental Health Summary Scales. 2d ed. Boston: The Health Institute, New England Medical Center.

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