By David Henderson
John Goodman posted yesterday on another post by law professor Jill Horwitz and economics professor Helen Levy. In their post, Professors Horwitz and Levy defend Obamacare from various criticisms. I won’t bother repeating John Goodman’s arguments. Rather, what I note is that their criticism repeats two common misunderstandings about insurance. They write:
Taking these two features of the law into account, it is not clear there will be much redistribution from young to old as a result of the ACA [Affordable Care Act] at all. There will, within each age group, be pooling of good and bad risks; by definition, this is how insurance works, and as noted above is a more efficient outcome than one in which markets do not exist because of adverse selection.
Actually, this is not how insurance works ideally. Insurance works by pooling equal or close-to-equal risks. A 90-year-old man, for example, will pay more for life insurance than a typical 25-year-old man. The reason seems obvious: the risk of a payout is much higher for the 90-year old than for the 25-year old. Similarly, a 21-year-old man will pay more for car insurance than a typical 50-year-old man. So the insurance company will invest in information to ascertain risk and will price accordingly.
Which brings me to their second error. They write that the pooling of good and bad risks “is a more efficient outcome in which markets do not exist because of adverse selection.” But the pooling of good and bad risks is the essence of adverse selection. Adverse selection arises because of asymmetric information: in the extreme, the insurance company cannot distinguish between good and bad risks and prices the same to everyone. Low-risk people, except the most risk-adverse among them, respond by not buying insurance; high-risk people find the insurance a good deal. The solution is for the insurance companies to figure out low-cost ways of ascertaining people’s risk and then to price higher to high-risk people and lower to low-risk people.
Disclosure: I am one of the signers of the brief that Professors Horwitz and Levy criticize.