What Is Adverse Selection in Health Insurance?

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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.

Adverse selection can lead to financial risks for insurance companies and higher health insurance premiums for consumers. The Affordable Care Act 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 have not eliminated adverse selection in health insurance markets.

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 person 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 deductible. Therefore, he would sign up for the plan, along with others in similar situations.

On the other hand, a 30-year-old 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.

Affordable Care Act 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.

If you wanted individual health insurance before 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 or not to accept or reject your coverage. Your medical history and pre-existing conditions would be examined in order to buy health insurance coverage. This process reduced risk to the health insurance company, and 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 purchase on state insurance marketplaces. Consumers 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 purchase 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 consumer, as all plans are guaranteed to be issued due to Obamacare. Therefore, this asymmetry of information can lead to financial losses for the insurer.

Initiatives by Obamacare to Reduce Adverse Selection

Obamacare included features that were designed to be solutions to and prevent adverse selection in the marketplace, such as:

InitiativeOutcome
Individual MandateA tax penalty that was imposed on anyone who did not purchase a health insurance plan that was qualified under the Affordable Care Act. It forced healthy individuals to buy a plan who might normally not purchase health insurance. This penalty will no longer exist during the 2019 policy period.
Enrollment PeriodsPrevented individuals from acquiring health insurance outside the enrollment periods, unless they were subject to a qualifying event. Since people were required to purchase 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 SubsidiesThis helped people with average or low income to acquire health insurance who would normally not be able to afford health care.

Even with these policies in place, insurance companies still face adverse selection. For instance, data has indicated that some consumers game the system by qualifying for special enrollment periods when they should not. A special enrollment period is a period of time which allows you to purchase health insurance outside of the mandatory enrollment periods. In this scenario, there's asymmetric information between parties, since the consumer is withholding that they may only be applying for health insurance because they happen to be sick. Furthermore, once they are not sick anymore, the consumer may just drop the health insurance because they do not require the coverage.

In addition, the individual mandate tax penalty is gone for the 2019 policy year, which may lead to an increase in adverse selection. Healthy people now do not face a penalty if they decide to go without health insurance coverage and may drop their individual health insurance plans if they cannot easily afford a policy.

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