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What used cars have to do with health insurance

Recently, the Maryland Health Connection — the online health insurance marketplace created under the Affordable Care Act — announced premiums as low as $114 a month for a bronze plan for a 20 year old and $260 for a silver plan for a 50- year old. Other state exchanges are announcing similarly low premiums. These affordable premiums in the individual market for health insurance by state health exchanges are tributes to the scholarly work four decades ago of George Akerloff.

Mr. Akerloff is a Nobel laureate economist who published a seminal paper, "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism" in The Quarterly Journal of Economics in August 1970. In this article, he describes how markets can degenerate and collapse if bad risks are able to drive good risks out of the marketplace. He uses the market for used cars as an example to illustrate this point.

If "lemons" are able to masquerade as good cars, buyers respond by lowering the price they are willing to pay for the average car to account for the possibility of buying a lemon. Consequently, sellers of good cars withdraw from the marketplace because they can't sell their cars for what they are worth. Hence that leaves a market with only lemons, which sell for a low price.

Health economists use Mr. Akerloff's argument to explain how uncertainty and asymmetric information negatively impact the market for health insurance by creating adverse selection. If someone who knows that he is going to need an expensive surgery is able to purchase health insurance right before he is admitted to the hospital, insurance companies will have to price their policies to account for this possibility. This pricing strategy causes others who do not have any foreseeable medical expenses to view health insurance policies as too expensive and to withdraw from the market. This leaves only those persons who need medical care in the near future in the market, which results in unaffordable premiums for everyone.

Adverse selection is a classic market failure that requires intervention. The insurance companies have a few tools at their disposal to address this problem, all of which are unsatisfactory from a societal point of view. To protect themselves from this opportunistic behavior, insurance companies can deny coverage for pre-existing conditions, reduce general coverage and charge extra fees or riders for certain conditions, impose lifetime limits on coverage, or refuse to sell policies to particular segments of the market. These tools reduce the financial risk of insurance companies but also shrink the market because they lower the value of health insurance while raising premiums for everyone. In other words, few pay more for less.

The Affordable Care Act, through state health insurance exchanges, applies a different remedy to this market failure, which from a societal point of view is better for everyone. Simply, it says that all buyers and sellers must be in the market. No one is permitted to act opportunistically. Insurers must issue policies to all prospective buyers, and all individuals must buy now and can't wait until they are sick. When everyone is in marketplace, the premiums come down to affordable levels. In other words, many pay less for more.

Darrell J. Gaskin (dgaskin@jhsph.edu) is an internationally known expert in health care disparities, access to health care for vulnerable populations and safety net hospitals. He is the deputy director of the Johns Hopkins Center for Health Disparities Solutions and associate professor of Health Economics at the Johns Hopkins Bloomberg School of Public Health. He is the vice chairman of the Maryland Health Benefit Exchange Board.

Copyright © 2015, The Baltimore Sun
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