Adverse Selection

Adverse Selection

One of the terms heard frequently in discussions of insurance programs is “Anti-Selection”.  Frankly, I don’t know what that means.  However, I do know about “Adverse Selection”, which is a much more meaningful term.  I would be very happy never to hear anyone say “anti-selection” again.

Insurance programs are created to pool risk.  A risk pool only works when the risks inside the pool are reasonably homogeneous.  If a party choosing to participate in a risk pool knows that they are exposed to much greater risk than others participating in the pool, then they are SELECTING AGAINST the pool.  Such selection will generally cause the experience of the pool to deteriorate, thereby generating an ADVERSE result for the pool as a whole.  Thus, we have the term ADVERSE SELECTION.

Some lines of insurance business are subject to more potential for adverse selection than others.  Social insurance programs (Medicare, Social Security, etc.) force all citizens to participate, so adverse selection is not a concern at enrollment.  These programs do struggle with fraudulent claim filings which is another problem.  Group insurance programs involve more adverse selection than social insurance programs because participation, at some level, is often voluntary.  The more people who are making decisions about participating or not participating in a risk pool, the more potential for adverse selection exists.  Employers can greatly reduce the potential for adverse selection in group insurance programs by subsidizing the premiums.  Individual insurance programs include the most potential for adverse selection because many people are making decisions to participate and paying the cost of their policies.

The Affordable Care Act (ACA) in the US created a number of text-book examples for rampant adverse selection.  One of the most important objectives of ACA was to make medical insurance available to people who had pre-existing conditions.  People with pre-existing conditions are, of course, the most motivated buyers of medical insurance.  We know that they will buy coverage, and we know that their claims will exceed their premiums.  This adverse selection was supposed to be paid for by forcing people to buy medical insurance policies, similar to social insurance programs.  Unfortunately, the provisions intended to force people to buy coverage have not been sufficiently effective, and an insufficient number of people WITHOUT pre-existing conditions have purchased coverage.

Even small amounts of adverse selection can create big problems for insurance programs.  This will be the source of more blog posts in the near future.

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