What is it called when people with higher loss exposure have a tendency to purchase insurance more often than those of the average risk?

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What is risk pooling?
Is the size of a risk pool the only factor?
What is “adverse selection”?
Why is adverse selection a problem?
Why do premiums depend on who buys coverage?
How does risk pooling currently work in the individual market?
How does the ACA protect against adverse selection?
What if more flexibility were allowed in the ACA market rules?
What if some plans were allowed to avoid ACA rules altogether?

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What is risk pooling?

The pooling of risk is fundamental to the concept of insurance. A health insurance risk pool is a group of individuals whose medical costs are combined to calculate premiums. Pooling risks together allows the higher costs of the less healthy to be offset by the relatively lower costs of the healthy, either in a plan overall or within a premium rating category. In general, the larger the risk pool, the more predictable and stable the premiums can be.

Is the size of a risk pool the only factor?

No. Although larger risk pools are typically more stable, a large risk pool does not necessarily mean lower premiums. The key factor is the average health care costs of the enrollees included in the pool. Just as a pool with healthy individuals can result in lower-than-average premiums, a large pool with a large share of unhealthy individuals can have higher-than-average premiums.

What is “adverse selection”?

“Adverse selection” describes a situation in which an insurer (or an insurance market as a whole) attracts a disproportionate share of unhealthy individuals. It occurs because individuals with greater health care needs, when given the opportunity, are more likely to purchase health insurance and to purchase health insurance with richer benefits than individuals with fewer health care needs.

Why is adverse selection a problem?

Adverse selection increases premiums for everyone in a health insurance plan or market because it results in a pool of enrollees with higher-than-average health care costs. Adverse selection is a byproduct of a voluntary health insurance market in which people can choose whether and when to purchase insurance coverage, depending in part on how their anticipated health care needs compare with the insurance premium charged. The higher premiums that result from adverse selection, in turn, may lead to more healthy individuals opting out of coverage, which would result in even higher premiums. This process typically is referred to as a “premium spiral.” Avoiding such spirals requires minimizing adverse selection and instead attracting a broad base of healthy individuals, over which the costs of sick individuals can be spread. Attracting younger adults and healthier people of all ages ultimately will help keep premiums more affordable and stable for all members in the risk pool.

Why do premiums depend on who buys coverage?

Health insurance premiums are set to pay projected claims to providers, as well as insurers’ administrative expenses, taxes, and profit. The largest component of health insurance premiums is the medical spending paid on behalf of enrollees. As a result, health insurance premiums reflect the expected health care costs of the risk pool. Because health spending is skewed—that is, a small share of consumers account for a large share of total health spending—if a risk pool attracts a disproportionate share of unhealthy individuals, premiums will be higher than they would be if the risk pool attracted an average population.

How does risk pooling currently work in the individual market?

The Affordable Care Act (ACA) requires that insurers use a single risk pool when developing premiums. The single risk pool incudes all ACA-compliant plans inside and outside of the marketplace/exchange within a state. In other words, insurers must pool all of their individual market enrollees together when setting the prices for their products. This means that the costs of the unhealthy enrollees are spread across all enrollees.

How does the ACA protect against adverse selection?

The ACA includes a number of provisions that are intended to broaden participation in the individual market. Among the more significant of these are the individual mandate, premium and cost-sharing subsidies for low-income individuals, and a limited open-enrollment period. The ACA rules also support a level playing field. That is, the rules governing the insurance market regarding issue, rating, and benefit requirements apply equally to all insurers. In addition, the ACA includes a permanent risk adjustment program that transfers payments among insurers in the single risk pool based on the relative risk of their enrollees. By limiting the adverse selection in the market as a whole and mitigating the effects of enrollee risk profile differences among insurers, the single risk pool requirement, uniform market rules, risk adjustment program, and provisions to encourage enrollment work together to facilitate market competition and the ACA’s pre-existing condition protections.

What if more flexibility were allowed in the ACA market rules?

If insurers were able to compete under different issue, rating, or benefit coverage requirements, it could be more difficult to spread risks in the single risk pool. Currently, risk adjustment is used to calibrate payments to insurers in the single risk pool based on the relative risks of their enrolled populations. By reducing insurer incentives to avoid high-cost enrollees, risk adjustment helps support protections for those with pre-existing conditions. Some changes to market rules, such as increasing flexibility in cost-sharing requirements, could require only adjustments to the risk adjustment program. Other changes, such as loosening or eliminating the essential health benefit requirements, could greatly complicate the design and effectiveness of a risk adjustment program, potentially weakening the ability of the single risk pool to provide protections for those with pre- existing conditions.

What if some plans were allowed to avoid ACA rules altogether?

If some plans were allowed to avoid the ACA rules altogether, then plans competing to enroll the same participants wouldn’t be competing under the same rules. Noncompliant plans would likely be structured to be attractive to low-cost enrollees, through fewer required benefits, higher cost- sharing, and premiums that vary by health status. Higher-cost individuals would tend to want the broader benefits and pre-existing condition protections of ACA-compliant coverage. Rather than having a single risk pool, in which costs are spread broadly, there would be in effect two risk pools—one for ACA-compliant coverage and one for noncompliant coverage. As a result, average premiums for ACA-compliant coverage could far exceed those of noncompliant coverage, thereby destabilizing the market for compliant coverage. The instability would be exacerbated if market rules facilitate movement of people between the two pools (e.g., if people with noncompliant coverage can easily move to compliant coverage when health care needs arise).

By transferring payments among insurers based on the relative risk of their enrollees, the ACA risk adjustment program can reduce premium differences resulting from some insurers attracting more costly enrollees than others. However, risk adjustment programs transfer payments within the same risk pool, but not between pools, especially when the different pools have different issue and rating rules. Therefore, in a market with separate risk pools for compliant and noncompliant coverage, costs would no longer be spread over the broad enrollee population. In addition, for risk adjustment to work properly, the benefit coverage requirements need to be fairly similar across plans. Even if the compliant and noncompliant plans were pooled together for risk adjustment purposes, the potentially large differences in underlying benefits between compliant and noncompliant coverage would make risk adjustment extremely difficult to implement. And any resulting risk transfers from noncompliant plans to compliant plans would be very high, thus negating much of the premium advantages of noncompliant coverage. Instead of using risk adjustment to mitigate the higher premiums needed for compliant coverage, external funding could directed to the compliant pool, for instance in the form of a reinsurance program. However, the funding for such a program would have to be substantial and permanent.

Both moral hazard and adverse selection are used in economics, risk management, and insurance to describe situations where one party is at a disadvantage as a result of another party's behavior.

Moral hazard occurs when there is asymmetric information between two parties and a change in the behavior of one party occurs after an agreement between the two parties is reached. Asymmetric information refers to any situation where one party to a transaction has greater material knowledge than the other party. Moral hazard frequently occurs in the lending and insurance industries, but it can also exist in employee-employer relationships. Any time two parties come into an agreement with each other, moral hazards can be present.

Adverse selection refers to a situation where sellers have more information than buyers have, or vice versa, about some aspect of product quality, although typically the more knowledgeable party is the seller. Adverse selection occurs when asymmetric information is exploited.

Moral hazard and adverse selection are both terms used in economics, risk management, and insurance to describe situations where one party is at a disadvantage to another.
In a moral hazard situation, one party entering into the agreement provides misleading information or changes their behavior after the agreement has been made because they believe that they won't face any consequences for their actions.
Moral hazard frequently occurs in the lending and insurance industries, but it can also exist in employee-employer relationships.
Adverse selection refers to a situation where sellers have more information than buyers have, or vice versa, about some aspect of product quality.

In a moral hazard situation, one party entering into the agreement provides misleading information or changes their behavior after the agreement has been made because they believe that they won't face any consequences for their actions. When a person or an entity does not bear the full cost of a risk, they may have an incentive to increase their exposure to risk. This decision is based on what will provide them with the highest level of benefit.

There is always the risk that one party has not entered into a contract in good faith, and they may do this by providing false information about their assets, liabilities, or credit capacity. This can occur in the financial industry in contracts between a borrower and a lender. Moral hazard is also common in the insurance industry.

For example, assume a homeowner does not have homeowner's insurance or flood insurance but lives in a flood zone. The homeowner is very careful and subscribes to a home security system that helps prevent burglaries. When there are storms, they prepare for floods by clearing the drains and moving furniture to prevent damage.

However, the homeowner is tired of always having to worry about potential burglaries and preparing for floods, so they purchase home and flood insurance. After their house is insured, their behavior changes. They cancel their home security system subscription and they do less to prepare for potential flooding. The insurance company is now at a greater risk of having a claim filed against them as the result of damage from flooding or loss of property.

According to research by economists Allard E. Dembe at The Ohio State University and Leslie I. Boden at Boston University, the term moral hazard was widely used by insurance agents in England. Although early usage of the term implied fraudulent and immoral behavior, at times the word "moral" has also been used to simply refer to subjective behavior in the field of mathematics, so the ethical implications of the term are not clear. In the 1960s, moral hazard became a subject of study again amongst economists. At this time, rather than being a description of the morals of the involved parties, economists used moral hazard to refer to inefficiencies created when risks cannot be fully understood.

Adverse selection describes a situation in which one party in a deal has more accurate and different information than the other party. The party with less information is at a disadvantage to the party with more information. This asymmetry causes a lack of efficiency in the price and the number of goods and services provided. Most information in a market economy is transferred through prices, which means that adverse selection tends to result from ineffective price signals.

For example, assume there are two sets of people in the population: those who smoke and do not exercise, and those who do not smoke and who exercise. It is common knowledge that those who smoke and don't exercise have shorter life expectancies than those who don't smoke and choose to exercise. Suppose there are two individuals who are looking to buy life insurance, one who smokes and does not exercise, and one who doesn't smoke and exercises daily. The insurance company, without further information, cannot differentiate between the individual who smokes and doesn't exercise and the other person.

The insurance company asks the individuals to fill out questionnaires to identify themselves. However, the individual that smokes and doesn't exercise knows that by answering truthfully, they will incur higher insurance premiums. This individual decides to lie and says they don't smoke and exercises daily. This leads to adverse selection; the life insurance company will charge the same premium to both individuals. However, insurance is more valuable to the non-exercising smoker than the exercising non-smoker. The non-exercising smoker will require more health insurance and will ultimately benefit from the lower premium.

Insurance companies reduce exposure to large claims by limiting their coverage or raising premiums. Insurance companies attempt to mitigate the potential for adverse selection by identifying groups of people who are more at risk than the general population and charging them higher premiums. The role of life insurance underwriters is to assess applicants for life insurance to determine whether or not to give them insurance or how much premiums to charge them. Underwriters typically evaluate any issue that may impact an applicant's health, including but not limited to an applicant’s height, weight, medical history, family history, occupation, hobbies, driving record, and smoking habits.

Other examples of adverse selection include the marketplace for used cars, where the seller may know more about a vehicle's defects and charge the buyer more than the car is worth. In the case of auto insurance, an applicant may falsely use an address in an area with a low crime rate in their application in order to obtain a lower premium when they actually reside in an area with a high rate of car break-ins.

In both moral hazard and adverse selection, there is information asymmetry between the two parties. The main difference is when it occurs. In a moral hazard situation, the change in the behavior of one party occurs after the agreement has been made. However, in adverse selection, there is a lack of symmetric information prior to when the contract or deal is agreed upon.