Adverse selection happens when there is an imbalance between high-risk or sick policyholders and healthy policyholders within the realm of health insurance. The most common way of adverse selection occurring is when sick people who need more protection and coverage begin purchasing up policies in a higher rate than those who are healthy who need little to no coverage and may not purchase a plan at all.
This can eventually lead to significant financial issues within the insurance industry, amounting to higher health insurance premiums for users. While the Affordable Care Act, also known as Obamacare, attempted to find a solution for adverse selection issues through individual mandates and subsidized premiums, it has not reduced adverse selection in health insurance markets.
The Affordable Care Act also increased the adverse selection to insurance companies as they had limited ability to adjust their rates and availability of policies based on consumer details. This wasn’t an issue before, because they were able to control and protect themselves from adverse selection.
In the world of health insurance, adverse selection happens when higher-risk or sick policyholders, who have many coverage needs, buy health insurance, while healthy people either choose to wait to purchase insurance, or not be covered altogether. This then leads to an abnormal amount of healthy and unhealthy people registering for health insurance plans.
Here’s an example.
If a company offers an insurance plan with a premium of $500 per month and coverage for day-to-day health care issues, someone with heart problems and diabetes may look at the $500 plan as a significant deal as they’ll logically spend more on health care throughout the year than the $500 monthly premium plus deductible.
In contrast, a 41-year-old who is in excellent shape may view the $500-per-month plan as excessive. Others who are in similar good health may choose to find cheaper coverage or not purchase insurance at all.
Health insurance companies can be financially affected by adverse selection, thus generating fewer insurance providers to choose from or higher rates. As healthy people leave the health insurance marketplace, those who do stay insured are higher risk, which means that companies will be forced to repay more claims as many insured individuals are using more health care benefits.
Healthy people can also minimize the number of premiums insurance companies receive, forcing them to raise rates to make up the difference. However, the rising costs can lead to more healthy individuals giving up their policies altogether.