As the Senate prepares to consider health-care reform legislation, a key policy issue remains unsolved: how to prevent what industry insiders call “adverse selection.” The bills under consideration, including the one that the Senate Finance Committee recently approved, would impose major restrictions on insurance companies—forcing them to cover anyone, regardless of preexisting health conditions; barring them from setting premiums based on policyholders’ health; and limiting how much they could increase premiums because of policyholders’ age. These restrictions would lead to a disproportionate number of older, sicker people buying coverage, while the young and healthy delayed buying it until they needed it. That, in turn, would drive up the cost of insurance and threaten one of the legislation’s key goals: reducing the number of uninsured. And pricier insurance would doubtless lead to pressure for still more government intervention.

One possible response to this problem is simply for the government generously to subsidize insurance for the uninsured, encouraging the young and healthy to sign up—but that would be hugely expensive. So congressional Democrats are considering a second approach: offering less generous subsidies while requiring almost everyone, including the young and healthy, to buy insurance, and imposing sizable penalties on those who don’t comply.

But even if you accept the idea of mandating health insurance for everyone—an idea open to plenty of objections, both philosophical and practical—there’s a major problem with the Senate Finance Committee’s bill. In order to work, a government-imposed penalty would have to be severe enough to encourage most of the uninsured to buy insurance. The Senate bill, however, includes only modest penalties, with fines that increase gradually to $750 per year by 2017. That’s far less than the thousands of dollars that healthy people would have to pay for coverage. (The bill’s weakness has prompted insurance companies—which had previously agreed to support the new restrictions, provided that they were coupled with penalties strong enough to make everyone buy insurance—to start pushing back.)

The strength of the penalty, as it happens, is the issue in a dispute over the cost of health-care reform. In mid-October, PricewaterhouseCoopers (PWC) released a report, sponsored by America’s Health Insurance Plans, estimating that the Senate bill could increase average premiums for individual coverage 47 percent by 2016, compared with current law. Asked by Senate Democrats to respond to the PWC report, MIT health economist Jonathan Gruber argued in part that it had ignored Congressional Budget Office (CBO) projections that the bill would result in lower premiums. But there is a fundamental difference between the PWC’s analysis and the CBO’s: unlike the CBO, PWC considered the possibility that weak penalties for the uninsured would result in a disproportionate number of people with high medical costs purchasing coverage, significantly increasing average costs.

In fact, in a September 22 letter to Senate Finance Committee Chairman Max Baucus, CBO director Douglas Elmendorf acknowledged this. Other factors held equal, he wrote, “premiums in the new insurance exchanges would tend to be higher than the average premiums in the current-law individual market . . . because the new policies would have to cover preexisting medical conditions and could not deny coverage to people with high expected costs of health care.” He then noted that the “CBO has not analyzed the magnitude of that effect.”

There is a way for Congress to reduce adverse selection: relaxing the proposed restrictions on insurance companies. For instance, it might let insurers refuse to cover preexisting conditions, at least initially, for people who fail to buy coverage within a designated period after the bill takes effect. Or insurers could be allowed to charge these laggards a premium penalty, as they already can for Medicare Parts B (physician and outpatient services) and D (prescription drugs). Unfortunately, both options appear to be incompatible with the Democratic leadership’s philosophy of insurance reform. If they refuse to budge in their restrictions on insurers, though, they should at least acknowledge the expensive realities of that approach.


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