What is an adverse selection death spiral?

What is an adverse selection death spiral?

• A. The risk pool is not homogeneous; overcharged members leave; P* rises; premiums rise
• B. The risk pool becomes more homogeneous; premiums fall
• C. Government subsidies resolve the issue
• D. Insurers stop underwriting new policies

Answer: (A)

Adverse selection death spiral happens when there are differences in risk among applicants and pricing feeds that imbalance into a self-reinforcing cycle. If the pool isn’t homogeneous and the plan ends up being driven mainly by higher-risk individuals, the insurer’s expected costs rise. To cover those costs, the premium must rise. As premiums climb, healthier or lower-cost buyers find the plans too expensive and drop out. That leaves an even riskier pool, pushing premiums higher still, and more people exit. In short, the mix of risk deteriorates while prices escalate in a feedback loop. The option that describes a non-homogeneous pool, some members feeling the price is too high and leaving, and the break-even premium rising leading to higher actual premiums fits this idea of a self-reinforcing downward spiral. The other choices describe stabilization, policy remedies, or market withdrawal, none of which capture the escalating cycle.

Adverse selection death spiral happens when there are differences in risk among applicants and pricing feeds that imbalance into a self-reinforcing cycle. If the pool isn’t homogeneous and the plan ends up being driven mainly by higher-risk individuals, the insurer’s expected costs rise. To cover those costs, the premium must rise. As premiums climb, healthier or lower-cost buyers find the plans too expensive and drop out. That leaves an even riskier pool, pushing premiums higher still, and more people exit. In short, the mix of risk deteriorates while prices escalate in a feedback loop.

The option that describes a non-homogeneous pool, some members feeling the price is too high and leaving, and the break-even premium rising leading to higher actual premiums fits this idea of a self-reinforcing downward spiral. The other choices describe stabilization, policy remedies, or market withdrawal, none of which capture the escalating cycle.