Rating Of Losses In The Selection That Seizes In Health Insurance

Insurance Markets With Adverse

Adverse selection theory suggests that in markets characterized by asymmetric information, a statistically significant correlation exists between coverage and risk (Cohen and Siegelman, 2010). Adverse selection affects both the supply of and demand for health insurance. Health insurers may undersupply in anticipation of consumers’ potential use of private information (Lieberthal, 2016) and low-risk insureds consume less health insurance than they would in a market free of adverse selection (Browne, 1992; Browne and Doerpinghaus, 1993). 

However, evidence that demonstrates the presence of adverse selection in the U.S. health insurance market is mixed (Cutler and Zeckhauser, 2000).2 Prior empirical studies have focused on samples of one insurer (e.g., Van de Ven and Van Vliet, 1995), one employer (e.g., Ellis, 1985; Cutler and Reber, 1998), or one state (e.g., Luft, Trauner, and Maerki, 1985; Buchmueller and Feldstein, 1997), of one market (e.g., Browne, 1992; Browne and Doerpinghaus, 1993; Hofmann and Browne, 2013), or of one age group (e.g., Cardon and Hendel, 2001; Fang, Keane, and Silverman, 2008). 

Due to data limitations, these prior studies are unable to evaluate adverse selection in a cross-section representative of the current overall health insurance market. Thus, the ability to generalize the results of these studies may be limited. We investigate the presence of adverse selection in the U.S. health insurance market using a dataset containing insured demographics and health insurance plan characteristics from 62 health insurers operating in the private market in 45 states from 2013 to 2017. 

With this novel dataset, we contribute to the existing literature by testing for adverse selection across state markets in a time period marked by substantial changes in the U.S. health insurance market. We document a statistically significant correlation between coverage and risk, providing evidence of adverse selection in both the individual and group markets for health insurance using the seminal positive correlation test proposed by Chiappori and Salanie (2000) and extended by Dardanoni, Forcina, and Li Donni (2018). 

Cohen and Siegelman (2010) note that future work in this area should focus not only on the documentation of a coverage-risk correlation but also on the identification of the circumstances where the presence of adverse selection is more likely to exist. Our unique and extensive dataset allows us to account for state-level and insurer-level heterogeneity that prior studies have not evaluated due to data constraints.

Background And Hypothesis Development 

Rating practices differ across health insurance markets (i.e., individual, small group, and large group). It is well-documented that the individual market is more prone to adverse selection. Pauly and Nichols (2002) argue that “a major market failure for individual coverage may be caused by insurers’ inability to distinguish some truly low risks.” 

The employer-sponsored nature of the group health insurance contract, on the other hand, suggests that the potential for adverse selection is less likely in the group market than in the individual market. In the group market, low risks can only exit the pool by foregoing the employer subsidy or by leaving employment (Mayers and Smith, 1981; Browne, 1992) and high risks only gain access if employed. 

The group market may experience less adverse selection because the rating of group coverage is based on the average experience of the group, effectively pooling low risks and high risks (Hall, 2000). 

The generous premium subsidies in the group market may lessen adverse selection because it keeps low risks in the pool of insureds. However, if employees are insulated from plan costs because the premiums are heavily subsidized by the employer, they may choose more generous plans which may lead to adverse selection in the group market (Cutler and Zeckhauser, 2000). 

If the individual choice is excluded altogether from a group insurance scenario, then group insurance may still experience the presence of adverse selection (Eling, Jia, and Yao, 2017).4,5 While insurers writing business in the large group market post-ACA are permitted to use experience rating, health insurers writing business in the individual and small group markets are restricted to the use of adjusted community rating, thus reducing their ability to charge rates based on risk classification. Adverse selection is the tendency for high risks to purchase insurance or to purchase larger amounts of insurance than low risks (Cummins et al., 1983). 

In health insurance policies, this phenomenon occurs when insureds have private information about their health risk (Neudeck and Podczeck, 1996). Health insurers can attempt to control for adverse selection through careful underwriting and benefit design, but severe restrictions on rating in health insurance policies make it more difficult for insurers to distinguish between insureds of differing risk levels.

Born, P. H., & Sirmans, E. T. (2020). Restrictive rating and adverse selection in health insurance. Journal of Risk and Insurance87(4), 919-933.

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