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Adverse selection in health insurance occurs when individuals have private information about their health risk that insurers cannot fully observe. Sicker people, knowing their expected costs are high, are more willing to purchase comprehensive coverage, while healthier people, knowing their expected costs are low, may forgo coverage or choose minimal plans. This self-sorting raises the average cost of the insured pool above the population average, forcing premiums up. Higher premiums drive out the next-healthiest group, further raising average costs — a feedback loop called the "death spiral" that can cause the insurance market to collapse. Adverse selection is the primary theoretical justification for the individual mandate, community rating (banning price discrimination based on health status), and risk adjustment mechanisms that underpin universal health coverage systems.
Insurance works by pooling risk: many people pay premiums, and the few who get sick have their costs covered by the pool. This arrangement benefits everyone ex ante — before anyone knows whether they will be sick. But it depends on a balanced pool containing both high-risk and low-risk individuals. Adverse selection threatens this balance by causing the pool to become progressively sicker and more expensive.
The mechanism is driven by asymmetric information. Individuals know more about their own health than insurers do. A 35-year-old who exercises daily, eats well, and has no family history of disease knows they are low-risk. A 35-year-old with diabetes, hypertension, and a family history of heart disease knows they are high-risk. If both face the same premium (based on the average 35-year-old's cost), the healthy person may decide the premium is not worth it — their expected costs are well below the premium. The sick person finds it a bargain — their expected costs far exceed the premium. When the healthy person leaves, the average cost of the pool rises.
The death spiral is the worst-case outcome: each premium increase drives out the next-healthiest group, raising costs further, until only the very sickest remain and premiums become unaffordable. This is not merely theoretical — pre-ACA individual insurance markets in many US states exhibited exactly this pattern, with insurers exiting markets, premiums spiraling, and sick individuals unable to find affordable coverage.
Three policy mechanisms address adverse selection. Individual mandates compel everyone to participate, maintaining a balanced risk pool by preventing healthy people from free-riding. Community rating prohibits insurers from charging different premiums based on health status, ensuring that sick people can afford coverage (but requiring mandates to prevent healthy people from opting out). Risk adjustment compensates insurers who enroll disproportionately sick populations, reducing their incentive to avoid high-cost enrollees (cream-skimming). These mechanisms work together: community rating without a mandate invites adverse selection; mandates without community rating allow risk-based pricing that excludes the sick. The interplay of these tools is the core architecture of universal health coverage systems worldwide.