"Some people just see you coming, I guess. They take one look and you and say, 'Oh boy...fresh meat!"
--Carla (Vision Quest)
Adverse selection occurs when information assymetries exist between buyers and sellers, resulting in undesirable outcomes for either the buyer or seller. These undesirable outcomes drive supply and/or demand from the market.
In economics, Akerlof (1970) elevated awareness of adverse selection by using information assymetry concepts to explain the frequency of 'lemons' in used car markets. Because buyers lack detailed knowledge about the quality of used cars for sale, they are generally not willing to 'pay up' for high quality cars. Owners of used cars see this, and are unwilling to put high quality used cars on the market. Less good cars on the market lowers the average quality of used cars on the market, which causes buyers to revise their average bid lower. As the bad drives out the good, the market spirals downward in quality and price.
Those familiar with Gresham's Law--the axiom that the production of bad money (e.g., fiat paper currency) drives out the good money (e.g., gold and silver coins--which people will take off the market and hoard)--should recognize the parallels. There are also parallels to the agency problem.
Akerlof's lemons problem aside, the term adverse selection originated years ago in the insurance industry. Here, information assymetry tilts toward the buyer. An adverse selection problem arises because high risk consumers, who are more knowledgable about conditions that might result in a claim, are more likely to purchase insurance policies than low risk consumers.
To cope with adverse selection, insurers collect background information on potential policy holders and run actuarial analyses to assess risk. By doing so, insurers seek to reduce information asymmetry. However, insurers might not know what information to collect to accurately assess risk, or government regulations may restrict what kinds of information insurers can be collected, thus leaving them exposed to more risk. To compensate for the unknown, insurers will be prone to increase policy prices although such increases may also be restricted by regulators. As such, providers might reduce supply or even choose to leave the market entirely.
People are getting a real time lesson in adverse selection as myriad problems surface with the Obamacare rollout. Key requirements of the law include a) insurers must provide coverage to all applicants while only being able to utilize some individual-specific information for pricing policies, b) all health insurance policies must be qualified (i.e., they must meet minimum standards specified by the federal government), c) all citizens are required to purchase health insurance (a.k.a. "the individual mandate") unless a special waiver is obtained from the government.
The design of Obamacare relies on pooling younger, healthier people (who currently pay no or low rates) with higher risk policyholders in order to reduce the adverse selection problem. However, getting the healthy demographic to literally buy in is certain to be a challenge. Fines associated with not buying a qualified policy are likely to be worth it to many Americans.
But the challenge associated with getting healthy into the risk pool just increased mightily. As ACA provisions have kicked in, insurers have begun increasing premiums and dropping coverage of many previous policy holders (two very predictable consequences, btw). The resulting uproar found people challenging the promise made by President Obama and his administration on many occaisions that people would be able to keep their existing insurance plans if they liked them.
The uproar reached such a feverish pitch last week that a few dozen Democrats sided with the Republican-controlled House to pass a bill permitting insurers to continue selling plans that would not be permitted under Obamacare. Absent such a legislative fix, defections by congressional Democrats fearful of political fallout from their constituencies could sound the death knell for the ACA right here.
But Obamacare's death spiral may be underway regardless. Incentives for the healthy to enroll have just decreased further. Adverse selection is set to bias the pool even more toward high risk enrollees. This will put more upward pressure on policy premiums.
If insurance commissions refuse to approve insurer rate increases, then capacity leaves the system. If rate increases are approved, then adverse selection kicks into high gear, concentrating more risk in the insured pool and making it even more costly to insure enrollees.
The bad drives out the good in a spiral toward market failure.
All of this in front of the midterm elections...
Akerlof, G. 1970. The market for "lemons": Qualitative uncertainty and the market mechanism. Quarterly Journal of Economics, 84: 488-500.