An insurance death spiral?

Yuval Levin has a very important piece up on NRO about the prospect of an insurance death spiral under Obamacare. My takeaway is that we’re more likely to see a runaway cost spiral than an insurance death spiral.

Levin begins by explaining the death spiral scenario:

An insurance death spiral, or adverse selection spiral, would be a kind of second-order consequence of the website fiasco: The fact that it is so difficult to sign up for exchange coverage may mean that only highly motivated consumers do sign up, and those are likely to be people with high expected health costs.

If the exchanges end up containing too many people in poor health and not enough people in good health, insurers could take massive losses in 2014 and be forced to dramatically raise premiums for 2015 plans to better price the risk they would be taking on. Those higher premiums would cause even more healthy people to avoid getting coverage, leaving the risk pool in even worse shape and so driving even further premiums hikes, and the cycle would continue.

The core problem here is the design of Obamacare — with its badly imbalanced risk pools in the exchanges — not the design of the website — which only exacerbates the problem. As Levin puts it, “the system was already precariously perched at the edge of disaster, and the website’s woes may push it over the edge but they are not responsible for the danger in the first place.”

But Levin points out that Obamacare also has a built-in mechanism that may prevent it from going over the edge:

The talk of a death spiral in recent days has often overlooked a crucial feature of the exchange system that provides a major cushion against the effects of cascading adverse selection, though not against a whole host of other related problems. . . .The protection is a function of the design of the law’s exchange subsidies.

An insurance death spiral is a feedback phenomenon—a bad risk pool in year 1 causes drastically higher premiums in year 2 which causes an even worse pool that year and on and on. The key to it is that it causes consumer premiums to go up so that only people with high expected health costs (for whom the high premium is still less expensive than staying uninsured) stay in and drive the cycle on.

But in the Obamacare exchanges, the subsidy system is intended to prevent people from feeling the effect of annual premium increases after the first year. The subsidies are designed to make sure that each recipient pays only a certain percentage of his income in premium costs. That percentage stays essentially the same year after year, so if premiums get more expensive the government covers the difference.

In other words, if premiums for coverage purchased in the exchanges were to double or triple in 2015 because of severe adverse selection, people eligible for subsides would still pay the same amount they did in 2014 (assuming their incomes didn’t change) and the federal government would pay for the entirety of the increase. Subsidized beneficiaries would therefore not feel the effect and the healthy among them would not necessarily have much reason to flee the exchanges.

The question becomes: what percentage of the people who buy coverage in 2014 will receive subsidies? The CBO has estimated that number to be 86 percent. Thus, the vast majority of purchasers probably would not feel the effect of second-year premium spikes. And this means that the result of any such spikes would likely not fall into the usual pattern of an adverse selection spiral.

Levin isn’t saying that the adverse selection problem would not be problematic. On the contrary:

The sort of severe adverse selection the exchanges may experience would dramatically increase federal spending and would drive unsubsidized exchange participants (other than those in very poor health) and many insurers out of the exchanges.

It could also destabilize the portion of the individual market that remains outside the exchanges, since it will not be possible to keep the parts of the individual market that are inside and outside the exchanges quite separate (in no small part because Obamacare requires insurers to treat plans they sell in those two markets as drawing on a single risk pool).

And it would be difficult to shield the employer-based insurance system from such effects too; if the exchange system were to become simply an ultra-expensive and poorly formed high-risk pool, the entire insurance system would pay the price.

This is something other than an insurance death spiral, but it could prove just as calamitous.