How Health Insurance Companies Prevent Adverse Selection

Receptionist giving insurance card to patient.
Eric Audras ONOKY/Getty Images

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.

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, health insurance companies would 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 health care procedure is so small.”

Meanwhile, a 64-year-old obese 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 health care 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 health care 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 pre-existing conditions from coverage, or by excluding certain types of expensive health care products or services 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 (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.
  • prohibits health plans from imposing annual or lifetime caps on benefits.
  • requires individual and small group health plans to cover a uniform set of essential health benefits; health plans can’t exclude certain expensive health care services or products from coverage.
  • 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 market (and to some extent, in the small group market), it established other means to help prevent unchecked adverse selection.

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 hefty tax penalty. The penalty was eliminated after the end of 2018, however, as a result of 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 percent higher (each year) than they would have been if the penalty had continued. That projected premium increase is a direct result of adverse selection, since it's 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. [Note that New Jersey, Massachusetts, and DC have their own individual mandates with penalties for non-compliance. Rhode Island and California will join them as of 2020.]

Premium Subsidies

The ACA provides subsidies to help those with moderate incomes buy health insurance in the health insurance exchanges so they’re more likely to enroll in a health plan. This factor is the primary reason the ACA-compliant individual markets have not faced a death spiral, despite significant rate increases in 2017 and 2018 (rates had mostly stabilized in 2019 in the majority of the states, and hardly budged for 2020). 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. [Unfortunately, there is currently no mechanism in place to keep coverage affordable for people who aren't eligible for premium subsidies; healthy people in that population are more likely to drop their coverage as premiums increase, and although subsidized enrollment has stayed fairly level, enrollment among people who have to pay full price has dropped significantly in the last few years.]

Limited Enrollment Windows

The ACA also places restrictions on when people are allowed to enroll in an individual market health plan so that people can’t wait to buy health insurance until they’re sick and know they’ll be incurring health care 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, requiring proof of the qualifying event, and 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. Coverage takes effect January 1 if a person enrolls during the fall open enrollment period (which runs from November 1 to December 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 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 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 that do not allow insurers to charge older people three times as much as younger people.]

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. 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 (note that 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).  

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Article Sources
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  2. Congressional Budget Office. Repealing the Individual Mandate Penalty: An Updated Estimate. November 2017.

  3. Gaba, Charles. ACA Signups. 2019 Rate Hikes.

  4. Gaba, Charles. ACA Signups. 2020 Rate Changes.

  5. Centers for Medicare and Medicaid Services. CMS Releases Reports Showing Declining Enrollment for the Unsubsidized Population. August 12, 2019.

  6. Norris L. Qualifying events that can get you coverage. December 19, 2019

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