As part of the most recent collective bargaining agreement with state

As part of the most recent collective bargaining agreement with state employees, a state government must offer dental insurance at “reasonable, nonprofit rates.” The state plans to self insure in place of using a private insurance company.

Statistical evidence suggests that the average household currently spends $300 per year for corrective dental work and $80 for routine checkups. Administrative costs are expected to average $20 per family. The collective bargaining agreement dictates that the plan’s coverages and rates be fixed for a period of three years. The auditor considers the choice of the plan to be extremely important. Consequently, the auditor has asked you to evaluate the three proposals listed below in terms of their propensity to result in adverse selection and/or moral hazard. Proposal 1 would charge a $400 premium with no deductible. Coverage is extended to preexisting conditions, but to cover the nondeductible clause, routine checkups are not covered. Proposal 2 charges a $200 premium with a $200 deductible. The plan does not cover preexisting conditions, but does cover routine office visits. Proposal 3 charges a $150 premium with a $150 deductible. This plan doesn’t cover preexisting conditions or routine checkups. The collective bargaining agreement dictates that participation in the plan must be at the employee’s option.

ANSWER

Plan 1 creates adverse selection difficulties because of the pre-existing condition coverage. Employees with existing dental problems would choose the plan in disproportionate numbers. The plan also creates a moral hazard because participants have little incentive to maintain their check schedules. Check-ups are not covered whereas dental problems are fully covered.

Plan 2 reduces adverse selection problems by excluding pre-existing conditions. Although adverse selection would still be present, it is not as significant as if preexisting conditions are covered. Coverage of the routine check-up should reduce or eliminate moral hazard difficulties. (This is the best plan.)

Plan 3 minimizes adverse selection by excluding preexisting conditions for the reasons discussed with Plan 2. The exclusion of coverage for the routine check-up should make moral hazard problems worse.