We economists discovered moral hazard and adverse selection in the mid-1980s. These terms came to us from the insurance industry and fit in well with our growing interest in information economics.
Of the two concepts, moral hazard has gotten more play than adverse selection. “Moral hazard” is a term used frequently in the business press. It explains current and past financial crises by showing that bad things happen when investors expect bailouts by lenders of last resort. The Southern European countries expect bailouts from their northern neighbors. Private mortgage lenders expect automatic bailouts from Freddie and Fannie. Buyers of Asian sovereign debt in the 1990s expected international agencies to bail out the lending countries.
Obamacare has brought adverse selection to the forefront. It explains and will continue to explain why Obamacare will not work. Adverse selection is routinely taught in law schools. I would imagine that President Obama encountered it in the course of his law training.
Adverse selection (to simplify) shows that private markets cannot provide insurance when only those most likely to need the insurance are willing to buy on a voluntary basis. For any private insurance market to work, there must be a broad pool of willing buyers, most of whom will never need the insurance. When only those who will need the insurance are willing buyers, there can be no private market.
We see the role of adverse selection in the Obama administration’s reluctant abandonment of its Community Living Assistance Services and Supports (CLASS) program. Only those likely to need long-term care support in the near future are prepared to buy into the program, but, with a likely outlay of $3,000 per month per claimant, premiums would be out of sight. Administration actuaries recognized reality and threw in the towel.
Adverse selection explains why Obamacare cannot survive without an individual mandate that requires all persons to buy into the program. Only through the individual mandate can Obamacare generate a sufficient insurance pool to pay, at least, for a significant part of the program. There appears to be no way to pay for all of it even with the individual mandate; so the general taxpayer will pick up much of the tab.
Whenever the government dictates the purchase of a product, there is no longer a private market, although we can pretend to have one, as the Obama administration intends to do.
I would hope that the Supreme Court will consider adverse selection when it rules on the individual mandate. It provides a stronger reason for rejecting the individual mandate than the overstepping of authority from the interstate commerce clause.
Paul Gregory is a research fellow at Stanford University’s Hoover Institution. He is an expert on the history of economics and author of numerous books, including Politics, Murder, and Love in Stalin’s Kremlin: The Story of Nikolai Bukharin and Anna Larina (Hoover Institution Press, 2010).