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What Is Adverse Selection in Health Insurance?
Adverse selection in health insurance is a case where sick people, who require greater health care coverage, purchase health insurance while healthy people do not. The situation can lead to an unbalanced distribution of healthy to unhealthy people who are insured. Adverse selection can present financial risks to insurance companies if left unchecked.
What Is Adverse Selection in Health Insurance?
by Sterling Price updated Aug 6, 2021
Adverse selection occurs in health insurance when there is an imbalance of high-risk, sick policyholders to healthy policyholders. The imbalance can happen due to sick individuals, who require more insurance, using more coverage and purchasing more policies than the healthy individuals, who need less coverage and may not buy a policy at all.
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Adverse selection can lead to financial risks for insurance companies and higher health insurance premiums for consumers. The Affordable Care Act (ACA) attempted to address these issues with certain policies, such as the individual mandate and subsidized premiums, which were intended to encourage enrollment. But these initiatives did not eliminate adverse selection in health insurance markets.
What is adverse selection?
Moral hazard vs. adverse selection
The Affordable Care Act's effect on health insurance companies
How does adverse selection work in health insurance?
In health insurance, adverse selection refers to the scenario in which higher-risk or sick individuals, who have greater coverage needs, purchase health insurance, while healthy people delay or decide to abstain. This can lead to an atypical distribution of healthy and unhealthy people signing up for health insurance.
For example, assume a company offers a health insurance plan with a premium of $500 per month and coverage for day-to-day health care issues. A man with heart problems and diabetes may look at the $500 plan and think that it is a bargain. This is because he knows that he will most likely spend more on health care throughout the year than the $500 monthly premium plus the deductible. Therefore, he would sign up for the plan, along with others in similar situations.
On the other hand, a 30-year-old woman in good health may view the $500-per-month plan as too costly. She, along with other healthy individuals, may decide to look for lower coverage policies or not buy insurance at all. The two scenarios result in a problem where the group of insured people contains a disproportionately high number of sick people who more frequently use their health care coverage.
What is the effect of adverse selection?
Adverse selection can negatively affect health insurance companies financially, leading to fewer insurers to choose from in the market or higher rates for those who purchase coverage. As healthy individuals drop out of the health insurance marketplace, the pool of insured people contains more high-risk policies. This means that the insurance company would be forced to pay out a larger portion of claims as compared to the number of policies in force because a disproportionately high number of insured people are utilizing more health care.
The lack of healthy people also can reduce the total amount of premiums that the insurance company receives. This then forces the insurance company to raise health insurance rates to make up the difference. But this can also lead to more healthy people giving up their policies due to the increased health insurance costs.
What is anti-selection?
Anti-selection is a term that is often used in conjunction with adverse selection. It is defined as an increase in the chance for a person to take out an insurance contract because they believe their health risk is higher than what the insurance company has allowed for in the premium amount.
Adverse selection occurs because of anti-selection behaviors by people with higher health risks. Since sick people are more inclined to enroll and use more coverage, the insurance company must increase rates to fund the excess claims. This, in turn, drives healthier applicants away from enrollment.
Moral hazard in health insurance
Moral hazard is the idea that a person who is insured will take on more risk and use more of a service than they would if they were not covered. In health insurance, moral hazard is the concept that an insured person will accept more risky health situations and then use more health care because they know that the cost will pass along to the insurer.
For example, assume someone purchased a moderately expensive health insurance policy. Every so often, for serious sickness and injury, they use the policy to go to the hospital and get care. But for common colds and other generic symptoms, which normally may not require doctor attention, they get treated as well. Since they know they are covered by the health insurance policy, they go to a health care professional for any problem they have. This can lead to an issue where more health care is being used relative to the premium amounts being paid.
In this example, moral hazard drives more use of health insurance as the insured takes on more risky situations in their life. This, combined with adverse selection, can lead to financial losses for the health insurance providers, as they are forced to pay out more claims and raise rates. In turn, as rates rise, the adverse selection makes health insurance less affordable for healthier people, which exacerbates the problem.
The Affordable Care Act's impact on insurance companies
The ACA increased exposure of adverse selection to the insurance companies due to the insurer having limited ability to adjust rates and availability of policies based upon consumer details. This was not as large an issue previously, as insurers had ways to control adverse selection and protect themselves from these situations.
Risk Pooling: How Health Insurance in the Individual Market Works
For a print-ready PDF of this page, click here.
Risk Pooling: How Health Insurance in the Individual Market Works
For a print-ready PDF of this page, click here.
What is risk pooling?
The pooling of risk is fundamental to the concept of insurance. A health insurance risk pool is a group of individuals whose medical costs are combined to calculate premiums. Pooling risks
together allows the higher costs of the less healthy to be offset by the relatively lower costs of the healthy, either in a plan overall or within a premium rating category. In general, the larger the risk pool, the more predictable and stable the premiums can be.
Is the size of a risk pool the only factor?
No. Although larger risk pools are typically more stable, a large risk pool does not necessarily mean lower premiums. The key factor is the average health care costs of the enrollees included in the pool. Just as a pool with healthy individuals can result in lower-than-average premiums, a large pool with a large share of unhealthy individuals can have higher-than-average premiums.
What is “adverse selection”?
“Adverse selection” describes a situation in which an insurer (or an insurance market as a whole) attracts a disproportionate share of unhealthy individuals. It occurs because individuals with greater health care needs, when given the opportunity, are more likely to purchase health
insurance and to purchase health insurance with richer benefits than individuals with fewer health care needs.
Why is adverse selection a problem?
Adverse selection increases premiums for everyone in a health insurance plan or market because it results in a pool of enrollees with higher-than-average health care costs. Adverse selection is a byproduct of a voluntary health insurance market in which people can choose whether and when to purchase insurance coverage, depending in part on how their anticipated health care needs compare with the insurance premium charged.
The higher premiums that result from adverse selection, in turn, may lead to more healthy individuals opting out of coverage, which would result in even higher premiums. This process typically is referred to as a “premium spiral.” Avoiding such spirals requires minimizing adverse selection and instead attracting a broad base of healthy individuals, over which the costs of sick individuals can be spread. Attracting younger adults and healthier people of all ages ultimately will help keep premiums more affordable and stable for all members in the risk pool.
Why do premiums depend on who buys coverage?
Health insurance premiums are set to pay projected claims to providers, as well as insurers’ administrative expenses, taxes, and profit. The largest component of health insurance premiums is the medical spending paid on behalf of enrollees. As a result, health insurance premiums reflect the expected health care costs of the risk pool. Because health spending is skewed—that is, a small share of consumers account for a large share of total health spending—if a risk pool attracts a disproportionate share of unhealthy individuals, premiums will be higher than they would be if the risk pool attracted an average population.
How does risk pooling currently work in the individual market?
The Affordable Care Act (ACA) requires that insurers use a single risk pool when developing premiums. The single risk pool incudes all ACA-compliant plans inside and outside of the marketplace/exchange within a state. In other words, insurers must pool all of their individual market enrollees together when setting the prices for their products. This means that the costs of the unhealthy enrollees are spread across all enrollees.
How does the ACA protect against adverse selection?
The ACA includes a number of provisions that are intended to broaden participation in the individual market. Among the more significant of these are the individual mandate, premium and cost-sharing subsidies for low-income individuals, and a limited open-enrollment period.
The ACA rules also support a level playing field. That is, the rules governing the insurance market regarding issue, rating, and benefit requirements apply equally to all insurers. In addition, the ACA includes a permanent risk adjustment program that transfers payments among insurers in the single risk pool based on the relative risk of their enrollees.
By limiting the adverse selection in the market as a whole and mitigating the effects of enrollee risk profile differences among insurers, the single risk pool requirement, uniform market rules, risk adjustment program, and provisions to encourage enrollment work together to facilitate market competition and the ACA’s pre-existing condition protections.
What if more flexibility were allowed in the ACA market rules?
If insurers were able to compete under different issue, rating, or benefit coverage requirements, it could be more difficult to spread risks in the single risk pool. Currently, risk adjustment is used to calibrate payments to insurers in the single risk pool based on the relative risks of their enrolled populations.
By reducing insurer incentives to avoid high-cost enrollees, risk adjustment helps support protections for those with pre-existing conditions. Some changes to market rules, such as increasing flexibility in cost-sharing requirements, could require only adjustments to the risk adjustment program. Other changes, such as loosening or eliminating the essential health benefit requirements, could greatly complicate the design and effectiveness of a risk adjustment program, potentially weakening the ability of the single risk pool to provide protections for those with pre- existing conditions.
How Adverse Selection Works in Health Care
There are several ways health insurance companies can avoid or discourage adverse selection. Learn about adverse selection in health insurance.
Adverse selection in health insurance happens when sicker people, or those who present a higher risk to the insurer, buy health insurance while healthier people don’t buy it. Adverse selection can also happen if sicker people buy more health insurance or more robust health plans while healthier people buy less coverage.
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Adverse selection puts the insurer at a higher risk of losing money through claims than it had predicted. That would result in higher premiums, which would, in turn, result in more adverse selection, as healthier people opt not to buy increasingly expensive coverage.
If adverse selection were allowed to continue unchecked, the resulting "death spiral" would cause health insurance companies to become unprofitable and eventually go out of business.
How Adverse Selection Works
Here’s a grossly simplified example. Let’s say a health insurance company was selling a health plan membership for $500 per month. Healthy 20-year-old men might look at that monthly premium and think, “Heck, if I remain uninsured, I’m probably not going to spend $500 all year long on health care. I’m not going to waste my money on $500 monthly premiums when the chance that I’ll need surgery or an expensive healthcare procedure is so small.”
Meanwhile, a 64-year-old person with diabetes and heart disease is likely to look at the $500 monthly premium and think, “Wow, for only $500 per month, this health insurance company will pay the bulk of my healthcare bills for the year! Even after paying the deductible, this insurance is still a great deal. I’m buying it!”
This adverse selection results in the health plan’s membership consisting mainly of people with health problems who thought they’d probably spend more than $500 per month if they had to pay their own healthcare bills. Because the health plan is only taking in $500 per month per member but is paying out more than $500 per month per member in claims, the health plan loses money. If the health insurance company doesn’t do something to prevent this adverse selection, it will eventually lose so much money it won’t be able to continue to pay claims.
The ACA Limited Insurer's Ability to Prevent Adverse Selection
There are several ways health insurance companies can avoid or discourage adverse selection. However, government regulations prevent health insurers from using some of these methods and limit the use of other methods.
In an unregulated health insurance market, health insurance companies would use medical underwriting to try to avoid adverse selection. During the underwriting process, the underwriter examines the applicant’s medical history, demographics, prior claims, and lifestyle choices. It tries to determine the risk the insurer will face in insuring the person applying for a health insurance policy.
The insurer might then decide not to sell health insurance to someone who poses too great a risk or to charge a riskier person higher premiums than it charges someone likely to have fewer claims. Additionally, a health insurance company might limit its risk by placing an annual or lifetime limit on the amount of coverage it provides someone, by excluding pre-existing conditions from coverage, or by excluding certain types of expensive healthcare products or services from coverage.
In the United States, most health insurance companies aren’t allowed to use most of these techniques anymore, although they were widely used in the individual (non-group) market prior to 2014. The Affordable Care Act:
prohibits health insurers from refusing to sell health insurance to people with pre-existing conditions.
prohibits insurers from charging people with pre-existing conditions more than it charges healthy people.1
requires individual and small group health plans to cover a uniform set of essential health benefits; health plans can’t exclude certain expensive healthcare services or products from coverage.
prohibits health plans from imposing annual or lifetime dollar caps on services that are considered essential health benefits (large group health plans are not required to cover essential health benefits—although most do—but if they do, they cannot impose lifetime or annual dollar caps on the amounts they'll pay for those services).
essentially eliminated medical underwriting for major-medical comprehensive health insurance (underwriting is still allowed for coverage that isn't regulated by the ACA, including things like short-term health insurance, limited benefit policies, and Medigap plans purchased after the enrollee's initial enrollment window). For ACA-compliant plans sold in the individual and small group markets, tobacco use is the only health/lifestyle-related factor that insurers can use to justify charging an applicant a higher-than-standard premium, although states can modify or eliminate the option for insurers to impose a tobacco surcharge.2
But the ACA Was Also Designed to Help Insurers Prevent Adverse Selection
Although the Affordable Care Act eliminated or restricted many of the tools health insurers used to use to prevent adverse selection in the individual market (and to some extent, in the small group market), it established other means to help prevent unchecked adverse selection.