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Adverse Selection and Employer Based Insurance Markets [EDITORIAL] BY JOHN MCCORMICK, APRIL 5, 2006

Any microeconomics 101 course worth its salt will try to provide examples of market failure. The most potent market failure arguments can tied to real world problems of information economics where one of the more famous examples used is "adverse selection".

Adverse selection is an insurance problem that occurs when those more likely to make a claim enroll in a policy. For example, healthy people may be less inclined to so sign up for insurance thus leaving insurers vulnerable to less healthy people signing up. Smokers may be inclined hide the fact that they smoke and thus get a mispriced premium at the expense of the healthy population causing the insurer to lose money, raise premiums and drive away more healthy people. Thus begins the downward spiral.

Employer based health insurance helps ameliorate this risk for insurers because risk is spread through large groups of employees. Larger and larger groups of employees means lower and lower premiums as risk is distributed over a population of workers. This is all well and good except for one real-world wrinkle: employer based health insurance premiums in the U.S. are rising to cover rapidly increasing healthcare costs.

Employer based health insurance premiums are rising so much a new type of adverse selection problem is beginning to threaten the employer based health insurance model. People with undisclosed health problems are becoming more inclined to seek jobs where health insurance is available thus increasing claims, which causes insurers to raise premiums thus making employers more attractive to less healthy workers who would otherwise be unable to afford the rising premiums.

Although the problem is still more in the domain of simulation models than real world empirical testing, there is one thing we know for sure: healthcare insurance premiums are on the rise and whenever rising premiums occur it presents an opportunity for adverse selection to rear its ugly head.

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