An insurance company offers a single plan at a premium based on the average population health cost. Healthy individuals find the premium too high relative to their expected costs and drop out. What happens next?
AThe premium decreases because there are fewer enrollees to cover
BThe average cost of the remaining pool rises, forcing the premium up, which drives out the next-healthiest group — a feedback loop (death spiral) that can collapse the market
CThe insurer profits because only sick people remain and they pay higher premiums
DNothing — the remaining enrollees are willing to pay the original premium
When healthy people exit, the remaining pool is sicker on average, raising the per-person cost. The insurer must raise premiums to cover these costs. The higher premiums make insurance even less attractive to the remaining relatively-healthy enrollees, so more leave. Each round of exits raises costs further. In the extreme, only the very sickest remain, premiums become unaffordable even for them, and the market collapses. This is the adverse selection death spiral — the canonical market failure in health insurance.
Question 2 True / False
The Affordable Care Act's individual mandate (penalty for not having insurance) was designed primarily to address adverse selection, not moral hazard.
TTrue
FFalse
Answer: True
The individual mandate forces healthy people into the insurance pool, preventing the adverse selection death spiral. Without it, healthy people could wait until they got sick to buy insurance (especially with guaranteed issue/community rating laws that prevent insurers from denying coverage or charging more for pre-existing conditions). The mandate addresses adverse selection by maintaining a balanced risk pool. Moral hazard, by contrast, is addressed through cost-sharing mechanisms (deductibles, copays) that reduce utilization among the already-insured.
Question 3 Short Answer
An insurer could eliminate adverse selection by charging each individual a premium exactly equal to their expected cost (perfect risk rating). Why don't most countries allow this?
Think about your answer, then reveal below.
Model answer: Perfect risk rating eliminates adverse selection but also eliminates the risk-pooling function of insurance — sick people pay their full expected costs, receiving no financial protection from the insurance arrangement. People with chronic conditions or genetic predispositions would face unaffordable premiums through no fault of their own. Most countries prohibit or limit risk rating because they consider access to affordable health insurance a social good that should not depend on health status. Community rating (charging everyone the same premium) combined with risk adjustment (compensating insurers who enroll sicker populations) achieves adverse selection control while preserving the social insurance function.
This illustrates the fundamental tension in insurance market design: actuarial fairness (premiums reflecting individual risk) prevents adverse selection but violates equity, while community rating (equal premiums regardless of risk) promotes equity but invites adverse selection. Every healthcare system must navigate this tension through regulation.