• Who discovered the death spiral?

    In March of this year Daniel McFadden, Carlos Noton, and Pau Olivella published an NBER paper on how health insurance markets fail and what can be done about it. From the abstract:

    An overall conclusion of the paper is that the design and management of creditable coverage mandates are likely to be key determinants of the performance of the health insurance exchanges that are a core provision of the PPACA of 2010. Enrollment mandates, premium subsidies, and risk adjustment can improve the stability and relative efficiency of the exchanges, but with carefully designed creditable coverage mandates are not necessarily critical for their operation.

    The paper is worth reading, but I’m not going to unpack it here. For fun, I’m going to focus on an unimportant detail. Who discovered the adverse selection death spiral?

    Perhaps the oldest surviving comment on this phenomenon is in Aristophanes’ comedy “The Frogs” in 405BC, where bad politicians driving good ones out of the political marketplace is compared to adulterated coins driving pure ones out of circulation. The impact of adverse selection on the debasement of money is enshrined in Gresham’s law, “bad money drives out good”, stated variously by Copernicus (1519), Gresham (1558), and Walford (1881). The modern recognition that adverse selection can lead to unraveling of a variety of contemporary markets, including products such as used cars, workers in the labor force, and health insurance, dates from the contribution of Akerlof (1970).

    Credit Aristophanes, but note the role of Copernicus and others.


    • Key to understanding Gresham’s Law is that bad money drives out good when bad money is made legal tender. In a system where good money and bad money are given the same legal treatment, good money will be preferred.

      Applied to health insurance, adverse selection occurs when the legal structure favors bad insurance. Currently the laws, tax policy and regulations favor pre-paid health care coverage over true insurance (risk management to protect against financial loss due to unpredictable events not under the control of the insured.) The ACA will outlaw medical underwriting and severely restrict the ability of insurance companies to charge actuarially accurate premiums. Under the ACA, the combination of MLR and cost-sharing limits will also effectively outlaw true catastrophic health insurance for all but the select cohort of “young invincibles.”

      So, Gresham’s Law is important to understand, but for different reasons than those presented above.

      If I am misinterpreting Gresham’s Law or the ACA, I would appreciate clarification. Thank you for all the work you do attempting to keep the debate honest and open.