Lewis & Ellis, LLC

Moral hazard and adverse selection

Health Care and Health Insurance
by Heather Robinson
The situations that result in moral hazard and adverse selection are important considerations for insurance companies.
The situations that result in moral hazard and adverse selection are important considerations for insurance companies.

The situations that result in moral hazard and adverse selection are important considerations for insurance companies. The impact the profit of the insurer, while simultaneously having the possibility of raising the cost of insurance premiums. While both deal with the insurers having an asymmetrical kind of client, they each have their own unique features. Let's break down the basics of these concepts, including when each idea occurs, what they mean and their impact on insurance premium rates. We will also briefly cover what can be done to reduce their negative effect on insurance companies.

Moral hazards

The concept of moral hazard is that if an individual has a certain kind of protection, they will act differently than if they were more vulnerable. This is an idea that is not just applicable to insurance but also impacts other fields as well. For example, a biker who is wearing a helmet might take risks that she would not otherwise have if she wasn't wearing a helmet. The same is true for those who are insured.

Because insurance companies offer payouts to their clients to protect them from the financial impact of an accident, the insured individual may be more likely to take risks because they know that they are protected. The ultimate worry for these businesses is that they will have to dole out more money than absolutely necessary if the individual were more careful.

We can look at collision repair insurance in vehicles as an example. Because the insured person knows the risk they face if they were to get into a car accident, they may drive more recklessly. Despite the obvious drawbacks of a collision, such as an injury, the financial repercussions are far less for those who have insurance. As a result, the driver may be more likely to speed or take unnecessary risks. 

The impact on insurance companies

Insurance companies want to mitigate the risky behavior that moral hazard can put them in. Even if the client is not intentionally taking advantage of their insurer, it can also happen unconsciously across all kinds of insurance. If there is a moral hazard present in a particular circumstance, there is usually an asymmetrical difference between the knowledge that each side has regarding the risks involved.

Moral hazard is also present in life insurance. Because most policies deal with sizable payouts, companies must mitigate the risks associated with it. One of the ways insurers can be sure that the individual is not too high-risk is to examine their background. Some of the following characteristics can be red flags for the insurance companies:

  • Mental health/suicide attempts.
  • Hospitalizations.
  • Risky career or hobbies.
  • Health conditions.

In other kinds of insurance, like property or a health insurance plan, hazards can result in more claims over time. When more claims are made, the cost of insurance premiums must go up which impacts the individual policyholder. There are a few ways to possibly limit moral hazard. For example, some insurance companies will reward good behavior such as driving safely or making healthy choices. In addition, insurers may be able to penalize bad behavior with higher rates or fees.

Adverse selection

Adverse selection is when an insurance company has an imbalance of high-risk policyholders to low-risk policyholders. This most commonly happens because more sick or ill people are willing to pay for insurance coverage due to the fact that their perceived needs are higher. On the other hand, healthy or low-risk people may not buy health insurance or even have less coverage in general. This is what leads to asymmetric information.

Insurance companies try to avoid adverse selection because it puts them at risk of having to pay more unnecessary claims due to the fact that there are more high-risk policyholders. In turn, the insurers have to raise the premium rate to mitigate the risk that they take on. This may cause the healthy, low-risk people to drop their coverage because it is too expensive and they do not think that they need it. In turn, this increases the adverse selection rate, which will eventually lead to a crash in the insurance market.

The Affordable Care Act (ACA) has impacted adverse selection by implementing policies that prevent insurers from refusing to insure someone based on components like health care history. Essentially, no insurance company can refuse an individual coverage because they can buy it on the state insurance marketplace. Due to this, insurance companies are more exposed to the impact of adverse selection.

How insurance companies limit adverse selection

Insurers have their own methods of protecting themselves from the high premium spiral that comes from adverse selection. This is one of the reasons why enrollment periods are enforced. Because people have to buy their insurance during a specific period of time, it limits the number of people who only get insurance when they need it.

The individual mandate was another example of insurance companies limiting their exposure to adverse selection. The mandate penalized people who qualified for insurance coverage and still refused to get it. This also applied to those who were low-risk, which would hopefully have encouraged more healthy people to buy a policy.

When it comes to risk assessments, these programs are established by the government to limit insurance risk. This will also help the policyholder because they will not have to pay higher premiums. If an insurance company has an asymmetrical amount of high-risk clients, this program will compensate them accordingly.

How adverse selection and moral hazards are connected

While the two situations are clearly different, adverse selection and moral hazard problems in the insurance industry have some similar components. In both circumstances, there is information asymmetry. This means that one of the two parties has more private information than the other. This is what causes the premium price to increase in an effort for the insurer to protect themselves from the perceived risk, for example.

The main difference between the adverse selection problem and moral hazard lies in when the imbalance occurs. When moral hazard happens, the issue happens as a result of the individual buying insurance coverage. On the other hand, the problem arises before the individual buys insurance in adverse selection. In both situations, one party is put at a disadvantage.

One of the ultimate impacts of these insurance results in higher premiums for policyholders. These terms are also used in other industries, like banking and loan industries, but they are most commonly used in a variety of insurance companies. These concepts must be managed closely because if they are left unchecked, the results can be extremely negative for both the insurer and the insured person. To learn more about how to protect yourself from exposure to both moral hazard and adverse selection, contact a Lewis & Ellis consultant today.



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