Not all adverse selection leads to a death spiral

Health plans in competition are unlikely to attract the same types of consumers. Some plans will be more attractive to relatively sicker people, thereby experiencing adverse selection. Others will be more attractive to relatively healthier people, thereby experiencing favorable selection.

Upon making that observation, it’s become fashionable in the health policy commentariat to make a nod to, if not build an entire argument, around the possibility of “death spiral” — that the plan(s) with the most adverse selection will enter into a downward spiral of premium hikes and loss of their (relatively) healthier customers, ending in smoldering ruin.

This is, of course, a possibility. But it isn’t a foregone conclusion that adverse selection leads to a death spiral. Were that the case, then whenever plans competed it’d be a fight to the death. But one doesn’t have to look very far to observe plans co-existing and in competition for years. It happens in the Federal Employee Health Benefits Plan. It happens in Medicare Advantage. It happens in Medicare Part D. It’ll probably happen in some of the new Obamacare marketplaces.

Apart from risk adjustment and other interventions that help plans survive adverse selection, the very nature of the market can also lead to inherent stability. Roger Feldman and Bryan Dowd explained two of them very nicely in a 1991 paper in the Journal of Health Economics. (I thank Dennis Shea for the tip.) They imagine an HMO in competition with a fee for service (FFS) plan. The former has a restricted network and lower premium, attractive to relatively healthier consumers (experiencing favorable selection). The latter has an unrestricted network and higher premium, attractive to relatively sicker consumers (experiencing adverse selection).

We join the story, already in progress, as the FFS plan is losing market share to the HMO. Is a death spiral underway (cue ominous music)?

Proponents of the ‘death spiral’ argument implicitly assume that the fair premium difference between the HMO and FFS rises as HMO enrollment share rises. They seem to forget that the HMO’s risk pool must become worse as its enrollment share increases. The only way the HMO can get a larger share is to attract FFS enrollees whose marginal risk is greater than the present average risk in the HMO. Thus the HMO’s average risk must rise. Whether this factor, by itself, stops the death spiral depends on the distribution of risks. For example, it can be shown than an exponential distribution of risks leads to a premium difference that widens as HMO enrollment share increases. The uniform distribution assumed in our earlier paper and explained above, implies a constant premium difference.

The second critical factor is the strength of peoples’ preferences for FFS insurance []. Proponents of the ‘death spiral’ argument either overlook this factor entirely or implicitly assume that even the last FFS enrollee would switch plans for a fairly small out-of-pocket premium difference. To the extent that FFS enrollees are loyal to their plan, this assumption will not be accurate and the premium spiral will tend to be self-limiting. We have found empirical evidence that employees will not readily switch plans if their present plan allows unrestricted choice of health care providers and the alternative plan limits this choice. This would be the case in a firm that offers a FFS plan and a group, staff, or network model HMO.

It’s worth mentioning that a fair amount of discussion about adverse/favorable selection these days isn’t between plans but between an entire market (an exchange) and options outside that market. That is, the question is often, will the selection into exchanges be more adverse than anticipated? Though exchanges have plans in competition, this question is analogous to imagining an exchange is just one big plan and consumers are choosing between it and nothing.* The cost of nothing does not increase as its market share grows (exchange participation shrinks), so at least one of the stabilizing mechanisms Dowd and Feldman describe doesn’t apply in this case.

* Some individuals have other worthwhile outside options, like employer plans or non-exchange, individual market plans. If one considers these, the story becomes complicated. I’m ignoring them for that reason.


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