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The turnabout in public opinion about managed care has been especially striking. In the space of only a few years, managed care went from being the centerpiece of many proposals for health reform to being the target of legislative action that forbids it the managerial actions that constitute its essence. What happened? Were the initial members of managed care plans overly accepting of restrictions they later discovered to be oppressive? Did plans change over time to become more aggressive? Or, is the controversy only political? We wish to suggest that there was more to the backlash than political mobilization of a few inevitable malcontents; rather, neither initial buyers nor original plans changed their views or behavior. Instead, a crucial part of the change, and a potential cause of the backlash, was a change in the kinds of people who were joining managed care plans. I The changes we will highlight are different from the kinds that can be easily brought into the policy analytical framework because they represent transfers among different sets of insured persons. The policy process must address the much more vexing question of who should gain and who should lose, with the total approximately constant. The source of this difficult problem, as with so many other problems in health insurance, is adverse selection.
Adverse Selection in Insurance: Theory
There is an economic theory of adverse selection in health insurance, well known among economists in general, that so far has had few realworld applications. This theory was developed by Michael Rothschild and Joseph Stiglitz (1976) to explain how competitive insurance markets would behave in a world in which everyone knows that buyers differ by risk levels but insurers are unable to distinguish among risks. Rothschild and Stiglitz show that, if potential insurance purchasers know their risk levels (if they can keep that information from insurers) and if insurers are willing to offer any potentially profitable contracts, a process of sorting or self-selection can ensue.
This process works in stages. Assume that the market begins with a single policy offered. If insurers cannot distinguish well among risk levels, the premium for the policy will be approximately "community rated"; that is, it will be similar for all potential buyers. However, such a situation cannot be...