When a health plan, insurer, or employer attracts a less risky and less costly group than the average (or than its competitors), it has experienced favorable selection. A plan that attracts a more risky and costly membership has unfavorable or adverse selection.  If the cost of health coverage is linked to the risk level of the pool of covered individuals, premiums for those who find themselves in groups with unfavorable selection will be higher, even if their own risk of medical care expense is low. The financial incentive then is for these lower-risk individuals to exit, making the remaining pool even more expensive, perhaps so expensive that even those most in need of the coverage cannot pay the premium and the plan fails.

Some argue that the solution to adverse selection is better information, so that everyone pays his or her exact risk-rated premium based on detailed personal information about health status, health behavior, work environments, and other factors affecting the risk of medical care expenses. This approach reflects a value judgment that the young and the healthy should not have to subsidize the old and the unhealthy (i.e., that risk segmentation is fair and desirable), a judgment with which the majority of this committee disagrees. For technical and practical reasons, perfect risk rating is unlikely if not impossible, so adverse selection related to information imperfections would still exist. (As described later in this chapter, technical problems also affect strategies to compensate for or discourage selection by risk adjusting employers' or governments' [not individuals'] payments to health plans.)

The policy problem with risk selection is not that it can put adversely affected health plans out of business. Rather, risk selection is a concern because it encourages socially unproductive competition based on risk selection rather than on cost-effective management of care for the ill and injured (GAO, 1991e; Hall, 1992; Light, 1992).3 Any strategy of health care reform that is based on competition and choices about health coverage should address these problems, and several options are discussed later in this chapter. Design of an appropriate strategy depends on an understanding of some of the factors that produce selection and the degree to which the insurers, the insured, and policymakers can manipulate them to exacerbate or control risk selection (Feldman and Dowd, 1991; GAO, 1991e; Light, 1992).


The charge that competition in accident and health insurance tends to focus on marketing rather than product quality is hardly new. For example, the following statement dates back to 1928: "[The] outstanding characteristics [of commercial accident and health insurance] are the heterogeneity of its policy forms and the non-scientific nature of its premiums . . . [Each is] a direct consequence of competition, which unlike competition in life and many casualty covers, devotes itself to the devising of new forms rather than to the emphasis of security and service on standard, or practically standard policies" (Kulp, cited in Faulkner, 1940, p. 1).

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