Insurance policies protect the people covered by them, against loss. The entire insurance industry is built on a system of pooling risk of unexpected losses amongst policyholders. This reduces the costs for policyholders, who enjoy protection against such losses for a monthly fee – a premium.
This system relies on a careful calculation of the risk of all policyholders. However, the entire system is in jeopardy when adverse selection comes into play. So what is adverse selection and why is it such a problem?
Read on to have adverse selection insurance explained, from the most common causes to its effects.
What Is Adverse Selection In Health Insurance?
Adverse selection is a situation that arises when the buyers and sellers of an insurance product don’t have the same information. More specifically, this means that the insurance company is unaware of all factors regarding the insured person’s health status.
Adverse selection happens when the correct knowledge for calculating probabilities and risk is unavailable to the insurer.
Examples Of Adverse Selection In Health Insurance
Here are some of the most common examples of adverse selection in health or life insurance.
- A smoker obtains life insurance coverage designed for a non-smoker. The insurance company is unaware of something that the insured person is aware of – their smoking status.
Because smoking is a risk factor that can affect their health and therefore their risk of smoking-related diseases, their life expectancy may be affected. This is information that the insurer should have had when underwriting the life insurance policy.
- A person purchases a health insurance policy but fails to disclose a personal or family history of chronic illness.
This will inevitably raise their risk of health problems, and their need for health care and medical interventions. The insurer should have had that information when approving the health insurance policy.
What Causes Adverse Selection Insurance?
As we explained above, adverse selection happens when the insurer is not privy to health information about the person they insure. But what causes this issue in the first place?
The insured person must disclose all information relating to their health. Therefore, adverse selection usually occurs because of deliberate withholding of information by the insured person. However, this is only sometimes the case. It can also occur if the insured person is unsure of what to disclose.
But the main reason adverse selection happens in insurance is economic.
High-risk individuals realize that they may have to pay much higher premiums because of lifestyle habits, like for example smoking, excess drinking, or substance use/abuse. Withholding such information may be their way to try to get a ‘better deal’.
What Is The Effect Of Adverse Selection?
Adverse selection has serious consequences for the health and life insurance industries.
In health insurance, the costs of providing care to people with unhealthy lifestyle habits are far greater than people without such vices. In life insurance, such unhealthy habits increase the odds (and so the risk) of premature death.
This means that adverse selection can cost insurance companies vast sums of money that they were not anticipating, in extra healthcare and early death benefit payouts. Because these risk factors were not calculated into their costs, insured people get the better deal but insurers get a bad one.
Insurers face higher claims and thus higher costs. But there are adverse effects for consumers, too.
Insurers may have to increase premiums or deny coverage to individuals with high-risk factors in their profile. The higher premiums may result in healthy individuals opting out of coverage. This leads to even higher premiums for everyone else. People refer to this as a ‘premium spiral’.
How Insurance Companies Fight Adverse Selection
Naturally, insurance companies do their best to avoid the problem of adverse selection. Here are some ways insurance companies address adverse selection.
Underwriting
Insurance companies use underwriting to assess the risk associated with each applicant. They gather information about the applicant’s health, lifestyle, and other relevant factors to determine the appropriate premium. This helps in pricing policies more accurately based on the individual’s risk profile.
Risk Classification
Insurers classify individuals into risk categories based on various factors, such as age, gender, health status, occupation, and lifestyle. They offer different premium rates for different risk groups.
Medical Examinations
Insurers may require applicants to undergo medical examinations. The exam results provide valuable information about an individual’s health and help insurers assess the associated risks more accurately.
Waiting Periods
Some insurance policies may have waiting periods before certain coverages become effective. This helps prevent individuals from purchasing insurance only when they anticipate needing to make a claim.
Continuous Coverage Requirements
Some health insurance plans may have continuous coverage requirements, which means individuals must maintain insurance coverage without significant gaps. This discourages individuals from purchasing coverage only when they need medical care.
Group Insurance
Group insurance, commonly offered through employers, can help mitigate adverse selection by pooling a diverse group of individuals. This group diversity helps balance the risk pool and prevents the concentration of high-risk individuals.
Mandatory Coverage
In some cases, the government may mandate individuals to have certain types of insurance, such as auto insurance. This helps ensure a broader and more balanced risk pool, reducing the impact of adverse selection.
Initiatives Of The ACA To Reduce Adverse Selection
Thanks to the Affordable Care Act (ACA), all policies are now guaranteed issues.This means everyone can access them, and they won’t discriminate against you for pre-existing health conditions. Yet this opens the door to potential adverse selection situations.
To counteract this problem, the ACA has introduced certain measures.
Tiered Health Plans
On the ACA health insurance marketplace, you’ll find many types of health insurance, offering different levels of coverage, at different price points. The health plans are organized into four metal tiers. These health plan metallic levels are bronze, silver, gold, and platinum.
Because of the great variety of coverage and benefits, you’re able to find the best deal for your and your family’s needs. Regardless of which tier you find most affordable (bronze plans are the cheapest), all plans across all tiers offer essential health benefits.
Premium Subsidies
The ACA made health insurance more accessible and affordable for all Americans. Despite this, many average Americans simply could not afford health insurance sign-up. The introduction of ACA premium subsidies resolved this problem.
Now you can apply for health insurance and, if you meet qualifying income-based criteria, for an ACA subsidy, too.
How does this reduce the problem of adverse selection? The problem is more pronounced amongst people who find insurance unaffordable. By making health insurance more affordable for everyone, adverse selection is greatly reduced.
Limited Enrollment Windows
Sign-up for ACA health insurance, or Obamacare, as it is commonly known, is limited to a particular enrollment window. This is called the Open Enrolment period, and except in cases of qualifying life events, no insurance enrollment is allowed outside this period each year.
It’s common for people to put off health insurance sign-up until they feel the need for it, because of poor health. But when people put off getting insurance until they get sick, the chances of adverse selection are high.
To prevent adverse selection, the health insurance enrollment period limits sign-up to a specific time, thus avoiding last-minute sign-ups.
Tobacco Surcharge
The ACA includes an allowable 1.5-to-1 ratio for tobacco use. Put more simply, individual and small-group health insurers under the ACA can charge policyholders who are tobacco users, up to 50% more than non-tobacco users.
Of course, ACA subsidies can help to lower the costs of health insurance. However, these subsidies cannot be used to cover the tobacco surcharge faced by smokers. They may still receive a subsidy, but it will be calculated at the amount they would pay if there was no tobacco surcharge.
It is a controversial measure, particularly as many people in lower-income groups are smokers.
Rating Ratio For Older Applicants
Older people are charged more than younger people for health insurance. This is capped at three times the rates that apply to a 21-year-old, which means older people may pay premiums as much as three times the cost of premiums for people under the age of 21.
This, too, is controversial and varies according to factors like location. In Massachusetts, for example, the cap on the age rating ratio is 2-to-1. New York and Vermont do not allow health insurance premiums to vary based on the insured person’s age.
Conclusion
Adverse selection occurs when people sign up for and are approved for insurance that does not meet their risk profile. This can happen because consumers are not aware of the need for full disclosure. Often, they are on tight budgets and are looking to save money on insurance.
Fortunately, it is still possible to get affordable insurance. The experts at Enhance Health will help you find the best health or life insurance that suits your budget and your risk profile. Together, we can find that great deal on insurance.
Contact us today to find insurance that’s right for you.
