If you think back to the days when you were studying for your insurance license, you may remember learning a couple terms that are related but have different meanings. In this post, we’ll discuss Adverse Selection and Moral Hazard and explain why both of these terms are relevant in today’s health insurance environment.

Adverse Selection

You’re probably familiar with adverse selection because we’ve heard about it A LOT since the Affordable Care Act was signed into law. Adverse selection normally occurs when one party in a transaction has information that the other does not and makes a decision based on that information.

A classic example, as Investopedia points out, is “the tendency of those in dangerous jobs or high-risk lifestyles to get life insurance.” In other words, these individuals know better than the insurance company that they are placing themselves in risky situations, and they act on that knowledge by buying an insurance policy that will pay money to their loved ones if something happens. This is similar to the fact that people with pre-existing medical conditions are more likely to purchase health coverage than people who do not have any ongoing conditions, and the likelihood of this circumstance increases when plans are guarantee issue with no medical underwriting, which means that insurance companies must accept all applicants who apply for coverage. Also, insurance companies are limited on the rates they can charge for people whose claims are likely to exceed their monthly premiums.

Under the Affordable Care Act, the individual mandate was intended to reduce the risk to insurance companies of adverse selection. The hope was that the threat of a financial penalty would be enough of an incentive to convince younger, healthier individuals to purchase health insurance.

Of course, many argued that the individual mandate was never strong enough and that there were too many exemptions for people without health coverage, so significant adverse selection still occurred, especially in the individual market. That’s part of the reason health insurance premiums are so high: insurance companies assume that those applying for coverage will have high medical claims, and because they cannot charge more on a per-person basis, they are forced to raise prices across the board.

Of course, the individual mandate penalty was reduced to zero beginning January 1, 2019, leading many experts to predict even more adverse selection and even higher health insurance premiums. We have seen that in some markets, but prices have actually declined in others. It’s possible that the mandate really wasn’t much of an incentive at all over the past five years and that we won’t see much additional adverse selection now that the penalty is gone.

Moral Hazard

Moral Hazard is a little different. It says that people with insurance actually change their behavior in a way that can lead to higher claims. And the more insurance they have, the more we witness this phenomenon. For instance, people with health insurance might engage in more risky behavior than they would if they were uninsured since someone else will pay the bill if they have an accident. Or someone who rarely uses health care services might actually seek more medical attention if he or she gets health insurance and can see a doctor for an affordable copayment.

CBS News explains it well in a 2013 article about moral hazard: “people who have health insurance are less likely to avoid health risks. As a result, they will go the doctor and use other medical services more frequently. That has the potential to increase health care costs.”

The whole purpose of the cost sharing requirements on a health plan is to reduce the likelihood of moral hazard. If people are required to pay a portion of the bill, they are more likely to use their health insurance efficiently and to engage in healthy lifestyles than they are if the insurance company is picking up the entire tab. Again from the CBS News article: deductibles and coinsurance help “to offset the incentive to take on too much health risk and to use medical services excessively.”

Why is moral hazard relevant today? Here are a couple examples:

For one, consumerism is still a big topic of discussion. At its heart, the goal of consumerism is to encourage people to make better healthcare decisions and, hopefully, make better lifestyle decisions as well. In other words, while consumers do have health insurance, which has a tendency to cause people to take risks they might not otherwise take, the likelihood of moral hazard is decreased because members are responsible for the first few thousand dollars of claims.

Similarly, starting in 2020, new Medicare recipients will no longer be able to purchase a Plan F supplement. The federal government has found that Medicare beneficiaries who have no out-of-pocket exposure tend to use a lot more health care services than those who have to pay an annual deductible and coinsurance. This is moral hazard at work.

Currently, a combination of original Medicare and a Plan F supplement eliminate almost all of the out-of-pocket exposure on Medicare-covered services, causing people to seek more medical care. Going forward, Plan G will be the most comprehensive supplement available to those aging into Medicare after December 31, 2019. These folks will have to pay, at a minimum, the Medicare Part B deductible, which is currently $185 and goes up a little each year. The hope is that by forcing beneficiaries to pay a portion of the cost of their health care services, there will be a reduction in moral hazard.

How to Impress Your Clients

It's unlikely that you’ll get too in-the-weeds when clients ask why individual premiums are so high or why Medigap Plan F is being eliminated, but if you really want to show them how smart you are, maybe you can work these terms into the conversation:

• “Health insurance premiums are high, especially in the individual market, due to adverse selection. People with high medical costs tend to buy health insurance while healthier people find other options, so insurers have to increase their prices to cover the cost of medical claims.”
• “Medigap Plan F is being eliminated because the government wants people to have some ‘skin in the game.’ When the entire cost of health care is covered by insurance, the way it is with Medicare and a Plan F supplement, this creates something called moral hazard for the insurance companies – basically, with no cost sharing, people tend to use a lot more health care services and engage in more risky behavior. Going forward, Plan G will be the most comprehensive supplement available. While it covers most of the out-of-pocket costs, Medicare recipients will have to pay the first $185 per year.”