Adverse Selection

Adverse selection occurs when individuals or groups with higher expected health care utilization join a risk pool designed for those with a lower expected utilization. A necessary condition for adverse selection is that the individual or group knows more about his (or her) future claims experience than does the insurer. In contrast, favorable selection occurs when those with lower future expected utilization join a plan designed for those with higher expected use.

Adverse selection poses a major challenge to health insurers. Consider an insurer that assigns all insureds to a single insurance pool. This is simple community rating. In such a plan, all those with coverage pay the same premium based on the average expected claims experience plus loading costs. If an individual knows he is likely to use a lot of medical care, he has an incentive to join this plan because his premiums will likely be less than the expected claims. Someone who knows she is a low user has an incentive not to join because the premium is well above the likely use of covered services. After people have joined the plan, insurer discovers that claims experience was greater than anticipated and premiums are likely to be insufficient to cover costs. Adverse selection is the reason for this. High-cost individuals joined and low-cost individuals avoided an insurance plan designed for average-cost individuals.

Because of adverse selection, insurers engage in underwriting. This is an effort to put individuals or groups into insurance pools or classes that reflect their likely future claims experience. Underwriting is based on relatively easily measured characteristics that are related to future claims experience. Thus individuals may be in different risk classes based on their age, gender, and prior health conditions. Group contracts can also entail adverse selection. Insurers deal with adverse selection in this case by underwriting based on the credibility of the group's prior claims experience relative to the insurer's overall book of business or by retrospective experience rating. In the latter case, the group's premium is based exclusively on the actual claims experience of the group in the current year. Such experience-rated premiums often include a stop-loss clause designed to limit the group's exposure to particularly high individual claims or to an unusually high overall claims experience.

Most empirical evidence on adverse selection comes from employer data on worker choices among the plans offered. Additional evidence comes from the Medicare program. The studies are nearly unanimous in finding biased selection (see Cutler & Zeckhauser, 2000, in the Further Reading section for this entry). Much of the research has examined enrollment into health maintenance organizations (HMOs) in contrast to conventional health insurance; the literature concludes that HMOs tend to attract people who use less health care. Many of these studies are designed to examine the utilization of workers before they have a choice of health plans. For example, let's say all workers for a firm are in a conventional employer-sponsored health insurance plan in year 1. In year 2 the firm offers a choice of a conventional plan and an HMO. Workers choose one or the other plan. Examining the claims experience of each set of workers in year 1 typically shows that those who ultimately chose the HMO had lower prior claims experience.

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