Without underwriting, individual coverage applicants on average cost 40% more than applicants for small group coverage. While the individual market provides insurers more opportunities to take rating actions and to improve their competitive positions, it also presents more risks than group insurance since individual health insurance applicants are collectively less healthy and have greater variance in their claim costs than applicants in other markets. For these reasons, the individual market is especially susceptible to adverse selection.
In this context, we loosely define adverse selection as the risk an insurer faces because only those who benefit from insurance at the offered price will buy it. People with poorer health are more willing to purchase health insurance coverage because they know they will need it.
While this represents a clear risk for individual insurers, it also presents a competitive opportunity. Making market-sensitive adjustments to the underwriting process, structure of family contracts, and rescission rules can provide a significant competitive advantage.
Ask and you shall receive
In the health insurance underwriting process, applicants often know much more about themselves than insurance companies do. Despite the best efforts of insurers to collect the information needed to make accurate underwriting predictions, applicants will provide–and withhold–information based on what they believe is in their best interest.
How can this dynamic be put to use? Consider this example of two different insurers. Insurer A uses very refined underwriting guidelines and detailed questions to make underwriting decisions. Insurer B uses less sophisticated underwriting guidelines and asks fewer questions. A sicker applicant will be more attracted to Insurer B, because it might seem more likely their ailments will escape full evaluation. A healthier applicant will be more attracted to Insurer A, because they have nothing to hide, and will likely receive a lower rate after the detailed underwriting process confirms their healthy status.
Therefore, the more rigorous Insurer A will attract healthy applicants, and the less rigorous Insurer B will attract sicker applicants. Over time, Insurer A can charge lower rates, while the opposite will be true for Insurer B. As rates for the less rigorous Insurer B are forced to rise over time, only the sickest members remain on the block of business, which then requires greater rate increases.
This cycle, or “death spiral,” of adverse selection is a significant concept in underwriting and an important reason to understand how rigorous the other insurers in your market are compared to your current methods. Clearly Insurer A has the more advantageous competitive position.
The structure of the rates used–tier factors versus member-level rating–provides another opportunity. A tier-factor approach might charge one rate for an employee, another for an employee plus spouse, and still another for a family. A member-level rate instead accumulates the individual rates for each person on the contract.