What Is Adverse Selection in Health Insurance?
Adverse selection occurs in health insurance when there is an imbalance of high-risk, sick people to healthy people. The imbalance can happen due to sick people, who require more insurance, using more coverage and purchasing more policies than the healthy people, 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 policyholders. 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.
How does adverse selection work in health insurance?
An example of adverse selection would be if a company offered 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 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.
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 people, 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 use their health care coverage more often.
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 get coverage. As healthy people 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 can also reduce the total amount of premiums that the insurance company earns. 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 that a person takes 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 extra 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 bought 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 compared 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 customer details. This was not as large an issue previously, as insurers had ways to control adverse selection and protect themselves from these situations.
If you wanted individual health insurance before the ACA, also called "Obamacare," you would have to go through an underwriting process with a specific insurance provider. Underwriters could use risk selection, the process of determining your health class, to decide on premium amounts and whether to accept or reject your coverage. Your medical history and preexisting conditions would be examined in the process of buying health insurance coverage. This examination reduced risk to the health insurance company, and lowered the likelihood of adverse selection, because it could utilize higher rates and be selective in accepting applicants.
Once the Affordable Care Act was in effect, individual health insurance was available to buy on state insurance marketplaces. People now had the ability to freely choose their own health insurance, and insurers could not deny coverage, as all health insurance was issued on a guaranteed-issue basis. This meant that if you wanted to buy health insurance, you could not be denied coverage due to preexisting conditions or your medical history. Since insurance companies did not have the ability to deny coverage, higher-risk people could acquire affordable health insurance, thus exposing the companies to adverse selection.
Adverse selection occurs due to asymmetric information passing between the buyers and sellers of the health insurance. The insurance company is largely unaware of the risk and health background of the buyer, as all plans are guaranteed to be issued due to the ACA. This lack of data can lead to financial losses for the insurer.
Initiatives by 'Obamacare' to reduce adverse selection
The ACA included features that were designed to solve or prevent adverse selection in the marketplace, such as:
Initiative | Outcome |
|---|---|
| Individual mandate | A tax penalty that was imposed on anyone who did not get a health insurance plan that was qualified under the Affordable Care Act. It persuaded healthy people to buy a plan who might normally not buy health insurance. |
| Enrollment periods | Prevented people from acquiring health insurance outside the enrollment periods unless they were subject to a qualifying event. Since people were required to buy health insurance during specific times and not simply when they became sick, this prevented a scenario in which a larger percentage of sick people were paying for health insurance for the limited period of time during which they needed coverage. |
| Premium subsidies | This helped people to acquire health care whose income would have normally prevented them from buying health insurance. |
Even with these policies in place, insurance companies still faced adverse selection. For instance, data has shown that some people game the system by qualifying for special enrollment periods when they should not. A special enrollment period is a period of time that allows you to buy health insurance outside of the required enrollment periods.
In this scenario, there's asymmetric information between parties, since the customer is withholding that they may only be applying for health insurance because they happen to be sick. Once they are not sick anymore, they may just drop the health insurance because they believe they no longer need it.
In addition, the individual mandate federal tax penalty is no longer in place. Healthy people may not face a penalty, depending on their state of residence, if they decide to go without health insurance coverage, and they may drop their individual health insurance plan if they cannot easily afford a policy.
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