Health care reform is surrounded by misinformation. For example, “death panels.” Death panels are a myth. But what doesn’t get talked about, despite being real and much more terrifying, is something called the adverse selection death spiral. The death spiral has the ability not to only derail the Affordable Care Act, but also to cause market collapse.*
A goal of the ACA is to reform the health insurance market, making sure everyone has coverage, and to keep coverage costs low. Two of the mechanisms created to achieve the goal are:
- Guaranteed issue: forces insurers to cover everyone.
- Community rating: insurers are limited in their ability to charge customers differential prices based on their health or risk profile.
No one is saying that insurers covering everyone is a bad thing, or that insurance companies should continue to charge sick people more than healthy people. Instead, there is a lot of concern over the unintended consequences of guaranteed issue and community rating—that they will actually lead to insurance costing more, due to the adverse selection death spiral.
To illustrate the unintended consequences, let’s imagine if the same reforms the ACA places on health insurers were to be put on flood insurers. The point is to strip the emotion out of the debate. Let’s put the life and death inexorably linked to health care aside, and just look at what these reforms will do to insurers. You don’t have to feel sympathy for insurers’ plight: but it’s worth considering if the reforms will lower the costs they’re charging you, or not.
The ACA For Flood Insurance?
First of all, under the Affordable Flood Act, you could call an insurer after a flood had hit your house, and the insurer would issue you a policy. Also, flood insurers could no longer base premiums on the likelihood of a flood happening. That means the price they charge someone living in a floodplain on the banks of the Mississippi can be no more than three times higher than what a person living in the desert outside Las Vegas pays. That translates to cheaper insurance for the Mississippi River floodplains, pricier coverage for the desert.
Now, remember, another provision of the Affordable Flood Act is that you must carry flood insurance. That means that those Vegas desert-dwellers have to buy. But what’s enforcing that provision? A fine—which costs less than the premiums for the newly upped insurance in the Vegas market. So, understandably, the desert homeowners start paying the fine rather than buying coverage. Why wouldn’t they? Not only is a flood unlikely—if it does happen, they can still call the insurance company and sign up while the water’s rising.
All insurance (flood, health, auto, etc.) allows people to protect themselves against the risk of huge losses by pooling both their premiums and risk together. Since the probability of all people suffering the same loss at the same time is low, the pool can afford periodic large payouts and protect everyone. In order for risk pooling to work, however, there must be a broad mix of risk levels among plan participants. But now, under the Affordable Flood Act, the only homes in the risk pool are risky and flood-prone. The relationship of costs between the riskiest and least risky keeps cycling up and up, and coverage gets more and more expensive.
Healthy People Get Out Of The Pool, Sick People Stay In
Though community rating is designed to make risky patients not pay more than healthy patients, it does not mean that everyone pays exactly the same amount. Rather, it creates a ratio, meaning that insurers can charge the most risky customers no more than three times what they charge the least risky. This 3:1 ratio governs the costs of premiums charged in the individual market.**
So community rating essentially means that on average, coverage will cost more than it does now for healthy people and less than it does now for sick people. Adverse selection means that the high costs for healthy people would drive them out of the health insurance marketplace or make them choose not to buy insurance at all (yes, you may have heard the ACA forces everyone to buy insurance – more on that later). Right now, healthy people buy insurance because they know if they get really sick later, they might be denied coverage because of their preexisting condition.
Guaranteed issue will change that—since you can’t be denied coverage, healthy people can just wait until they are sick to buy insurance.*** As the healthy people leave the exchange marketplace, the group of people in it becomes riskier and riskier.
Not only does the cost go up because the pool gets riskier, but insurers can exit the market—choosing not to sell insurance to individuals at all. For those individuals left in the risk pool, insurers’ exit from the market drives costs even higher.
How Do We Know The Spiral Is Real?
Community rating and guaranteed issue have been tried before—and many of the states who have tried them have since dropped those policies, or at least significantly changed them, due to something resembling the death spiral.
Analyzing the widespread effects of the revolutionary shifts in the insurance market is difficult, but of the 10 states that tried instituting the combination of community rating and guaranteed issue, almost all have either repealed or reformed the measures.
Key takeaways from these 10 states’ experience:
- Anticipation of the death spiral can cause insurers to leave the individual market.
- States that began with a 3:1 ratio for community rating often reformed the measure by widening the ratio.
- States that did not start with an individual mandate, or a requirement to buy insurance, sometimes had to add one.****
The Individual Mandate
The individual mandate has been all over the news lately—it’s controversial, because in some people’s mind it amounts to a tax, and a tax on not doing something. The individual mandate is the penalty you pay if you do not buy insurance. The point of the individual mandate is to stop the death spiral.
But the individual mandate penalty may not be strong enough to stop the death spiral. The penalty is $95 in 2014, and phase up to $325 in 2015, eventually reaching $695. In fact, the Supreme Court recently ruled to uphold the in mandate in part because the enforcement mechanism was not stringent. Part of Chief Justice Roberts’ justification for agreeing that the tax was a tax, and not a penalty, was that a Congressional Budget Office study expects four million people per year will pay the IRS the fee rather than buy health insurance. “We would expect Congress to be troubled by that prospect if such conduct were unlawful,” Roberts wrote. “That Congress apparently regards such extensive failure to comply with the mandate as tolerable suggests that Congress did not think it was creating four million outlaws. It suggests instead that the shared responsibility payment merely imposes a tax citizens may lawfully choose to pay in lieu of buying health insurance.”
But if four million people per year do “lawfully choose to pay” the penalty, we will see the death spiral. Without a strongly enforced individual mandate, it seems as though the goals of guaranteed issue and community rating are likely to fail.
*LoSasso, A. “Community Rating and Guaranteed Issue in the Individual Health Insurance Market.” The National Institute for Health Care Management: Expert Voices. January 2011.
**The health insurance market can be split into five segments: large group, small business, government-provided, the individual market and the uninsured. Today, the individual market, where people shop for their own, non-employer provided coverage, makes up about 4% of the marketplace. But under the Affordable Care Act, this segment of the market will see an influx from the uninsured population.
***The exchange does have an annual open enrollment period. This is meant to counteract adverse selection–so if you got sick in March, you might not be able to purchase coverage until October (for instance).
****“The Impact of Guaranteed Issue and Community Rating Reforms on States’ Individual Insurance Markets,” Milliman, March 2009.