The Health Insurance Sector: Asymmetric Information and The Lemon Problem

By Econoobics(http://econoobics.blogspot.com/)

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Economind’s remark:

If you are anything like me at all, in his previous article, Econoobics might have already convinced you that University Health Care is not a good route to take. However, it won’t be Economics without a bit of twist that surprises you. This is article is a continuation of the previous one: “Introduction to Univeral Health Care: Understanding the Pros and Cons”, but the author will bring you closer to understanding the rationale behind the decision that brings about Universal Health Care. Again, Econoobics uses US as his case study in this article.

I do not own or generate any of the content. All credit goes to Econoobics (He is human by the way).

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Source: http://www.cnn.com/2012/06/27/politics/btn-health-care/

Last time we talked about the disadvantage side of a universal health care. We also learned that the United States does not have a universal health coverage for American people unlike other industrialized countries. Today we will again focus on health economics and discuss some of the market failures of the American health insurance sector. Most of my arguments are inspired by Professor Gruber of MIT who is known as the architect of the new health reform in the U.S. You can find my reference at the end of the article and view his interesting lectures about the health insurance sector in America. I apologize for not preparing a standard reference of the articles that I cite. For simplicity I will show the link to the original articles so that you can use for future reference.

The World’s Ranking of America’s Health Care in the World

No doubt the United States is the most powerful nation on earth. Generally speaking, America loves to be number one. America is the number one largest economy in the world. America is number one when it comes to her total mighty military spending. America is number one in the movie industry, that is, the Hollywood movies generate billions of dollars at the box office. America also claims to be a leading country in promoting democracy and human rights in other countries. Well, the lists can go on and on. Despite having said that, when it comes to healthcare, America is nowhere near the number one spot in the world. That is according to the World Health Organization (WHO). Surprisingly, WHO ranked American healthcare system at number 37 in its 2000’s World Health Report. (http://www.who.int/whr/2000/en/). France’s health system was proudly ranked at number one. Another 2014 report of The Commonwealth Fund titled “Mirror, Mirror on the Wall, 2014 Update: How the U.S. Health Care System Compares Internationally” shows that American health system is ranked last among other 11 industrialized nations. You can find the latest report through this link. (http://www.commonwealthfund.org/~/media/files/publications/fund-report/2014/jun/1755_davis_mirror_mirror_2014.pdf)

Despite being on the number 37 spot in WHO’s world health system ranking and last in the latest 2014 The Commonwealth Fund’s report, as a matter of fact, Uncle Sam is spending a lot more on healthcare as a percentage of the GDP than any other industrialized countries in the United Europe. In fact, the U.S. spent 17.9% as a percentage of its GDP on healthcare in 2012, that is, almost 1 in 5 dollars in income is spent on the cost of health care.(http://data.worldbank.org/indicator/SH.XPD.TOTL.ZS) It leaves us perplexed to learn that the most powerful nation is not number one in healthcare or at least in the top ten list.

Source: http://www.lean.org/images/shook_hcchart.gif

The Rising Cost of Health Care

According to the U.S. Census Bureau, 48 million Americans did not have health insurance coverage in 2012. To put the number in context, 15.4% of Americans were uninsured, that is, about 2 in 10 Americans were not covered by health insurance.

(http://www.census.gov/hhes/www/hlthins/data/incpovhlth/2012/highlights.html). As a result, overwhelming health care spending on tests and hospitalization has been a leading cause of personal bankruptcies and homelessness in America. That is at least according to the National Health Care for the Homeless Council (NHCHC). In 2008 NHCHC estimated that health problems were responsible for 50% of personal bankruptcies in America. (http://www.nationalhomeless.org/factsheets/health.html) It is indeed a very concerning data for the 48 million uninsured Americans.

The cost of health insurance has also surged gradually over the past decades. In fact, the 2014 Employer Health Benefits Survey conducted by the Kaiser Family Foundation and the Health Research & Education Trust (HRET) found that “the average annual premiums for employer-sponsored health insurance are $6,025 for single coverage and $16,834 for family coverage.” (http://kff.org/report-section/ehbs-2014-summary-of-findings/)

Imagine a person who earn $2,000 per month and could he pay this kind of health insurance premium? This is why it is crucial to have a job in America so that you can be covered by the health insurance. As health insurance is getting more expensive along with the growing cost of health service, more and more people are unable to buy a health insurance plan. Young and healthy people also hesitate to purchase health insurance given its cost and perceived benefits.

Market Failure of the Health Insurance Sector

A large proportion of Americans receive their health insurance plans paid by their employers which is one of the means to attract talented individuals to work for their companies. Although some people are able to afford a health insurance plan, it does not necessarily guarantee that your health insurance application will be approved by the insurance company. To be more specific, some people are not qualified for health insurance given their pre-existing conditions. In other words, say for example John (a make-up name) has been diagnosed with kidney problems. To insure himself against future health hazards, he decides to obtain a health insurance policy from an insurance company called XYZ. Imagine if you were the one who run the insurance company XYZ, would you provide health insurance to John who has kidney failure, although you somewhat know that John has a high chance of getting sick at anytime? The insurance company might be generous and it is willing to help their clients, because the clients and the companies should grow together. That sounds good right? Insurance companies, however, are undeniably profit-oriented and there is a high probability that they would make a loss in the future if they decide to cover John. So is that a good business decision? Unsurprisingly, that is one of the many reasons why many people dislike insurance companies and labeled them as bloodsuckers and immoral. But that is what businesses do and how they operate to minimize cost and maximize profit. Are their behaviours right or wrong? There is no clear cut answer here. The answer lies in the gray area.

In addition to those who are not approved to be covered by health insurance, there is another market failure identified by economists in the health insurance market, caused by asymmetric information or in other words, the situation in which someone holds more information than another person. In the health insurance market, the buyer of the health insurance more often than not understands more about his own body and health condition better than the insurance companies. To avoid paying high premium for his health insurance coverage, the buyer could obscure his real health condition. Let’s say prone-to-illness people would be more inclined to buy a health insurance than healthy and young people. Because of asymmetric information in this insurance product’s transaction, the insurance companies risk making a loss due to covering the cost of the opportunistic and unhealthy people. The insurance companies, consequently, would mitigate such risks by raising the premiums of the health insurance coverage. This increase in health insurance premium would ensure that insurance companies can make a profit in light of these kinds of uncertainty. In turn, more healthy people would stop paying the health insurance premium due to its increased cost, which drives the insurance companies again to raise the premium. This vicious cycle is a market failure in the economy or what economists specifically call the Lemons Problem or the Market of Lemons. That is the reason why insurance companies may choose to deny coverage of the buyers with pre-existing condition or even refuse to renew the coverage if he is found seriously sick.

Source: http://insideops.com/wp-content/uploads/2014/06/used_car_lemon.png

There is another group of uninsured people. They certainly want to be insured in the case of any personal calamity, but the problem is they simply cannot afford to pay the health insurance premiums. They are the people who are living under the U.S. government’s poverty line. To be more specific, the poverty threshold in 2013 on average for a family of four is $23,834, according to the U.S. Census Bureau. (https://www.census.gov/hhes/www/poverty/data/threshld/)

The bottom line is that due to asymmetric information, health insurance premiums have gradually increase which make it not affordable for many American and cause healthy people to stop buying the insurance coverage. On top of that, insurance companies also deny health insurance coverage to those who have pre-existing conditions or stop renewing the health coverage once the policyholder get sick. That is why there are close to 50 million Americans who were living without health insurance in 2012. These are some of the problems to manifest the fact that there is a market failure in the health care system in the U.S. The explanations also justifies the role of the government to intervene in the healthcare insurance industry. So how would the government fix this problem? I planned to discuss Obamacare in this article, but it appears that this article is unexpectedly long already. For this reason, I decide to keep the discussion on Obamacare for the next article. Thanks for spending time reading this long article Stay warm everyone!

– The article is for educational purpose. (No copyright infringement intended)

– The article does not represent the view of any institution or organization.

You may also want to go to MIT’s OpenCourseWare from which I learn a lot about American health insurance market.

Gruber, Jonathan. 14.01SC Principles of Microeconomics, Fall 2011. (MIT OpenCourseWare: Massachusetts Institute of Technology),

http://ocw.mit.edu/courses/economics/14-01sc-principles-of-microeconomics-fall-2011(Accessed 17 Nov, 2014). License: Creative Commons BY-NC-SA