How Health Insurance Companies Prevent Adverse Selection

Adverse selection in health insurance happens when sicker people—or those who present a higher risk to the insurer—buy health insurance while healthier people don’t buy it. Adverse selection can also happen if sicker people buy more health insurance or more robust health plans while healthier people buy less coverage.

This article will explain why adverse selection is bad for a health insurance risk pool, what health insurers do to avoid it, and how government programs can mitigate adverse selection issues.

Adverse selection puts the insurer at a higher risk of losing money through claims than it had predicted. That would result in higher premiums, which would, in turn, result in more adverse selection, as healthier people opt not to buy increasingly expensive coverage.

If adverse selection were allowed to continue unchecked, the resulting "death spiral" would cause health insurance companies to become unprofitable and eventually go out of business.

How Adverse Selection Works

Here’s a grossly simplified example. Let’s say a health insurance company was selling a health plan membership for $500 per month. Healthy 20-year-old men might look at that monthly premium and think, “Heck, if I remain uninsured, I’m probably not going to spend $500 all year long on health care. I’m not going to waste my money on $500 monthly premiums when the chance that I’ll need surgery or an expensive healthcare procedure is so small.”

Meanwhile, a 64-year-old person with diabetes and heart disease is likely to look at the $500 monthly premium and think, “Wow, for only $500 per month, this health insurance company will pay the bulk of my healthcare bills for the year! Even after paying the deductible, this insurance is still a great deal. I’m buying it!”

This adverse selection results in the health plan’s membership consisting mainly of people with health problems who thought they’d probably spend more than $500 per month if they had to pay their own healthcare bills.

Because the health plan is only taking in $500 per month per member but is paying out more than $500 per month per member in claims, the health plan loses money. If the health insurance company doesn’t do something to prevent this adverse selection, it will eventually lose so much money it won’t be able to continue to pay claims.

The ACA Limited Insurer's Ability to Prevent Adverse Selection

There are several ways health insurance companies can avoid or discourage adverse selection. However, government regulations prevent health insurers from using some of these methods and limit the use of other methods.

In an unregulated health insurance market, health insurance companies would use medical underwriting to try to avoid adverse selection. During the underwriting process, the underwriter examines the applicant’s medical history, demographics, prior claims, and lifestyle choices. It tries to determine the risk the insurer will face in insuring the person applying for a health insurance policy.

The insurer might then decide not to sell health insurance to someone who poses too great a risk or to charge a riskier person higher premiums than it charges someone likely to have fewer claims.

Additionally, a health insurance company might limit its risk by placing an annual or lifetime limit on the amount of coverage it provides someone, by excluding coverage for pre-existing conditions, or by excluding certain types of expensive healthcare products or services (such as specialty drugs) from coverage.

In the United States, most health insurance companies aren’t allowed to use most of these techniques anymore, although they were widely used in the individual/family (non-group) market prior to 2014. The Affordable Care Act:

• prohibits health insurers from refusing to sell health insurance to people with pre-existing conditions.
• prohibits insurers from charging people with pre-existing conditions more than it charges healthy people.
• requires individual and small group health plans to cover a uniform set of essential health benefits, with specific coverage rules set by each state; health plans can’t exclude entire categories of expensive healthcare services or products from coverage.
• prohibits health plans from imposing annual or lifetime dollar caps on services that are considered essential health benefits (large group health plans are not required to cover essential health benefits—although most do—but if they do, they cannot impose lifetime or annual dollar caps on the amounts they'll pay for those services).
• essentially eliminated medical underwriting for major-medical comprehensive health insurance (underwriting is still allowed for coverage that isn't regulated by the ACA, including things like short-term health insurance, limited benefit policies, and Medigap plans purchased after the enrollee's initial enrollment window). For ACA-compliant plans sold in the individual and small group markets, tobacco use is the only health/lifestyle-related factor that insurers can use to justify charging an applicant a higher-than-standard premium, although states can modify or eliminate the option for insurers to impose a tobacco surcharge.

But the ACA Was Also Designed to Help Insurers Prevent Adverse Selection

Although the Affordable Care Act eliminated or restricted many of the tools health insurers used to use to prevent adverse selection in the individual/family market (and to some extent, in the small group market), it established other means to help prevent unchecked adverse selection.

Risk Adjustment Program

The ACA's risk adjustment program is specifically designed to protect insurers from the impact of adverse selection. If an insurer's plans are designed in a way that attracts sicker enrollees, the insurer will receive a payout under the risk adjustment program. And conversely, insurers with plans that attract healthier enrollees will have to pay into the risk adjustment program.

Without the risk adjustment program, insurers would be incentivized to design plans—within the general parameters of state and federal rules—that don't appeal to people with high-cost medical conditions. But thanks to risk adjustment, there is no incentive for insurers to do that, since they'll end up paying into the risk adjustment program to support insurers whose plans appeal to sicker enrollees.

Here's where you can see an overview of the insurers that owed money into the risk adjustment program for 2022, as well as the insurers that received a payout under that program. The federal government publishes a similar document each summer with details for the previous year.

The ACA also had a reinsurance program and a risk corridors program, both of which also served to mitigate the effects of adverse selection. But those programs were temporary, and only ran through 2016 (the risk corridor program was also underfunded and didn't work as initially intended).

Numerous states have implemented their own reinsurance programs over the last several years, utilizing 1332 waivers in order to obtain federal funding for their programs.

A Requirement to Maintain Coverage

From 2014 through 2018, the ACA required all legal residents of the U.S. to have health insurance or pay a tax penalty. This encouraged younger, healthier people who might otherwise have been tempted to save money by going without health insurance to enroll in a health plan. If they didn’t enroll, they faced a tax penalty.

The requirement to maintain coverage still exists, but the penalty was eliminated after the end of 2018 by the Tax Cuts and Jobs Act, which was enacted in late 2017.

The Congressional Budget Office estimated that the elimination of the individual mandate penalty would result in individual market premiums that are 10% higher (each year) than they would have been if the penalty had continued.

The increased premiums—relative to what they would otherwise have been—are a direct result of adverse selection. This is because it's only healthy people who are likely to drop their coverage without the threat of a penalty, resulting in a sicker group of people left in the insurance pool.

It's noteworthy, however, that the number of people with individual market coverage purchased through the health insurance exchanges remained quite steady, even after the individual mandate penalty was eliminated. And enrollment has increased in recent years—mostly due to enhanced premium tax credits, aka premium subsidies.

These subsidies are a crucial part of preventing adverse selection and are addressed in the next section. But the number of people paying full price for individual market coverage has dropped considerably over the last few years.

In DC and four states (New Jersey, Massachusetts, Rhode Island, and California), residents are still required to maintain health coverage or pay a penalty on their state/district tax returns. These states have acted on their own to take this step to prevent adverse selection in their insurance markets.

In Massachusetts, the requirement to have health coverage predates the ACA; it was widely regarded as a model for the ACA's individual mandate. DC and the other states imposed their own individual mandates after the federal government eliminated the federal penalty for not having minimum essential coverage.

Premium Subsidies

The ACA provides subsidies, in the form of premium tax credits, to help those with moderate incomes buy health insurance in the health insurance exchanges. Direct financial assistance to make health coverage affordable results in healthy people being more likely to enroll in a health plan.

This factor is the primary reason the ACA-compliant individual markets did not face a death spiral, despite significant rate increases in 2017 and 2018. The premium subsidies grow to keep pace with the premiums, which means coverage stays affordable for people who are subsidy-eligible, regardless of how high the retail prices go.

(Rates had mostly stabilized in 2019 in the majority of the states, hardly budged for 2020, remained quite stable again for 2021, and only increased by a very small amount for 2022. For 2023, overall rates grew by about 6%, and similar rate changes are expected for 2024.)

Prior to 2021, there was a "subsidy cliff" at 400% of the poverty level. Above that income limit, households were not eligible for premium subsidies, regardless of the percentage of their income they'd have to pay to buy coverage. But the American Rescue Plan (ARP) eliminated the subsidy cliff through the end of 2022, and the Inflation Reduction Act (IRA) extended that rule change through 2025.

This helps to prevent adverse selection among higher-income households. With the subsidy cliff in place, healthy people with income above 400% of the poverty level are more likely to forego coverage. But with the subsidy cliff eliminated, these applicants have access to affordable coverage.

As of early 2023, more than nine out of ten Marketplace enrollees were receiving premium subsidies that made their coverage more affordable. The ARP and IRA made marketplace coverage more affordable for most enrollees, making it easier and more appealing for people to purchase coverage—even if they were 100% healthy.

And indeed, Marketplace/exchange enrollment hit a record high in 2022 and again in 2023, driven in large part by the ARP/IRA subsidy enhancements.

Limited Enrollment Windows

The ACA also places restrictions on when people are allowed to enroll in an individual market health plan. This means people can’t wait to buy health insurance until they’re sick and know they’ll be incurring healthcare expenses.

People are only allowed to sign up for health insurance during the annual open enrollment period each autumn, or during a time-limited special enrollment period triggered by certain life events like losing job-based health insurance, getting married, or moving to a new area.

And subsequent rules have tightened up the regulations pertaining to these special enrollment periods, in many cases requiring that the person already had some sort of coverage in place prior to the qualifying event.

These limited enrollment windows already applied to employer-sponsored health insurance and Medicare, but individual market plans were available year-round prior to 2014—albeit with medical underwriting in nearly every state.

In Most Cases, Coverage Doesn't Take Effect Immediately

Federal regulations allow a short waiting period between the time someone enrolls in health insurance and the time coverage begins. So in most cases, a person cannot enroll in a health plan after a medical event and obtain coverage for that event (there are exceptions, such as COBRA and retroactive Medicaid, but those are not part of the individual, self-purchased health insurance market).

Coverage takes effect January 1—or in February or March, depending on the enrollment date—if a person enrolls during the fall open enrollment period (which runs from November 1 to January 15 in most states).

For those who enroll during a special enrollment period, coverage is effective either the first of the following month or the first of the second following month, depending on the state and the circumstances (in the case of a new baby or adopted child, coverage is backdated to the birth or adoption date; all other enrollments have prospective effective dates).

Tobacco Surcharge

Although the ACA eliminated nearly all medical underwriting in the individual market, it allows health insurers in the individual and small group markets to charge smokers up to 50% higher premiums than non-smokers. Some states, however, have restricted or eliminated this provision.

3:1 Rating Ratio for Older Applicants

Although premiums in the individual and small group markets cannot vary based on health status or gender, the ACA allows health insurers to charge older people up to three times more than they charge young people. Older people tend to have more medical expenses than younger people, and thus present a higher risk to the insurer.

There are a few states, however, that do not allow insurers to charge older people three times as much as younger people.

And it's important to point out that premium subsidies are also larger for older people, in order to offset those higher premiums. If two people have the same income, the premium subsidies will bring their after-subsidy cost for the benchmark plan down to the same level. That requires a larger subsidy for the older person, since their full-price premium is also larger.

Actuarial Value Differences

The ACA established uniform tiers of coverage based on actuarial value, allowing insurers to charge more for health plans with a higher actuarial value. In almost all cases, gold plans cost more than bronze plans, so consumers who want the more robust coverage offered by a gold plan must pay more to get it.

But there are some pricing oddities in the individual market as a result of the Trump administration's decision to stop reimbursing insurers for cost-sharing reductions; in many states, silver plans can be more expensive than some gold plans as a result.  

Summary

Adverse selection refers to a situation in which healthy people do not enroll in health coverage, while sick people do. This can result in a health plan losing too much money and not being able to continue to provide coverage.

To avoid adverse selection, health plans in the individual/family market used to use medical underwriting to ensure that all of their enrollees were fairly healthy. The ACA eliminated that practice, but it also included a variety of reforms to prevent adverse selection, including premium subsidies, age-rated premiums, and limited enrollment windows.

A Word From Verywell

Although health insurance might feel expensive if you're perfectly healthy and not in need of care, you never know when your medical needs might change. You can't just sign up for coverage anytime, which is why it's important to maintain coverage throughout the year.

If you're not eligible for employer-sponsored health insurance, you might be surprised to see how affordable health coverage can be in the marketplace/exchange. That's especially true now with the American Rescue Plan's subsidy enhancements in place, and their extension through 2025 by the Inflation Reduction Act.