In Part I of this discussion of the American Prospect debate over the public health insurance option, I discussed the importance of having a government sponsored "exchange" which Ezra Klein and the American Prospect’s Paul Starr strongly support. I also noted this:

Neither Klein nor Starr note that the Urban Institute’s paper describes both the public exchange and the public plan working together. It’s how they work together that determines how well they achieve the transformative and efficiency benefits of both. The exchange establishes the rules for reformed, efficient behavior, while the public plan modeled on those rules puts competitive pressure on private plans to make the reforms or lose market share.

That means businesses and consumers can chose to switch plans. So we have to design the rules by which they make those choices, and then think through what happens to the money.

Picking up the debate, Starr questions whether Congress can correctly define all the rules needed to avoid adverse selection:

That approach creates two points of vulnerability that could end up undermining reform. First, employers would decide whether to provide insurance directly or to pay into an insurance exchange. Firms with young and healthy workers are likely to insure directly, while those with higher-cost workers go into the exchange. That means the risk pool in the exchange would start out on the wrong foot — or in the lingo of insurance, it would suffer from "adverse selection."

Second, within the exchange, the public option would compete against private insurers, many of which have built their businesses by avoiding people with high medical costs. Some of the techniques they have used in the past would be prohibited, but they are still likely to be able to game the system.

Moreover, many people favor the public option precisely because they see it as needed for the chronically ill, people with disabilities, and other groups who haven’t been well served by private insurers. The trouble is that if the public plan is favored by those groups, it will have higher costs. In the world of health insurance, no one wants to be in a "club" with sick people, so over time the healthy would migrate to private plans, and the public option would become a choice of last resort.

Starr then proposes several rules, which may not go far enough, to reduce the incentives for "dumping" the most costly individuals into the exchange (and hence to the public plan):

First, the exchanges need to have broad-based risk pools. That would be the case if all employers with fewer than, say, 100 employees were required to purchase coverage through the exchanges (an idea that even Alain Enthoven, the father of "managed competition," recently endorsed in The New York Times). The exchanges might also be workable if the terms offered to small and midsize employers were so attractive that few of them decided to buy coverage outside.

Second, all insurers in the exchanges must be subject to rules that make it impossible for them to deny coverage, or to discourage the sick from enrolling, or to use marketing or other strategies to cherry-pick the healthy. The exchanges must also have the power to implement a system of risk adjustment that provides a bonus to plans if, after open enrollment, they find themselves with a population with predictably higher costs and that imposes a tax on plans that sign up a population with predictably lower costs.

Notice that Starr appears to assume a framework in which there are two mostly separated markets with only limited crossover: (1) one market in which employers choose between plans available to and through employers, and (2) another market for different plans offered in the exchange, which might be subject to different rules.

The first question to ask is, shouldn’t plans offered to/through employers meet the same reform principles as those in the exchange?

It’s the artificial separation of these two markets, and the potential for inter-market switches based on "adverse selection," that complicate the incentive problems that worry Starr. Wanting to preserve this separation (because some Senators think the goal is to shield private plans offered to employers from competition) is also where the Senate Finance Committtee is most likely to fail when developing revenue/tax mechanisms.

This artificial market separation is an unnecessary, complicating barrier. In essence, it could shield plans offered to employers from the effects of reform efforts, because the reforms are concentrated in the exchange. But if most people are covered at work and that’s where cost inefficiencies and discrimination occur, then it’s essential that the reforms reach that part of the market. Any unwarranted distinctions between "employer-provided" plans and "exchange" plans for everyone else need to disappear.

It would be helpful to have the Prospect’s (and other) discussions continue, but for participants to ask whether the adverse selection problems become simpler if we had one integrated market.

For example, why shouldn’t the plans offered to/by employers be the same plans offered to individuals in the exchange? (That is, all basic plans are in the exchange, and employers choose from those plans, including the public option.) Wouldn’t this solve the "discontinuity" problem (h/t Ezra Klein) Hill staffers are worried about? And shouldn’t all such plans meet the same basic qualifications for coverage, non-discrimination, risk-sharing, etc.? How can you solve adverse selection, or implement fair risk sharing transfer schemes, if the choices are subject to different rules?

By the way, the answers to these questions will tell us whether Kuttner or Reich is correct about which structure we need to be building. But that’s another post.

More:
Ezra Klein, Hill Staffer explains why employer-offered plans need to be in the exchange.
Klein, but House staffer clarifies the House bill eventually solves the problem