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"Adverse Selection" happens when unusually high-cost people select an insurance plan. Informally, people often use the term adverse selection when people with expected costs that are higher than a population average sign up for a policy. For example, suppose the average expected cost for employees at a company is $2,000 and that one of the health plans offered by the company attracts people with an average expected health care cost of $3,000. The insurer might complain about "adverse selection" -- saying that people who selected that plan are sicker than average. A better definition of "Adverse Selection" is that the people who sign up for an insurance plan have costs that are greater than the expected costs that the insurance plan used to calculate the premium. If sicker-than-average people sign up for a health plan with a higher-than-average premium, this is not adverse selection. For example, if an insurer knows that people selecting the plan will have an average expected cost of $3,000 and sets the premium accordingly, then this is not technically adverse selection. When adverse selection occurs, the average expected cost of people in a plan is higher than the insurer planned. The insurer loses money. If the insurer then raises the premium, the higher premium causes relatively lower cost people to drop the policy, which pushes up the average cost of those remaining. The insurer loses money again and raises the premium again. Again, this forces lower cost people to drop out. This vicious cycle (sometimes called the "Premium Death Spiral") continues until only the highest cost people are left in the policy. Most people have then dropped out and are uninsured. At first, one might think that adverse selection is just a problem for insurance companies because it causes them to lose money. However, adverse selection can cause problems for consumers as well when it causes them to be unable to get health insurance at fair prices. Adverse selection can be reduced by letting insurers set more accurate premiums by giving them more information or lifting restrictions on how premiums are set. However, this makes chronically-ill and high-risk people pay higher premiums. Adverse selection can be also reduced by restricting consumer choice by offering only one insurance plan for a group or by mandating that everyone buy a given plan. However, this reduces consumer choice and flexibility when different people prefer different plans. Finally, adverse selection can also be reduced by restricting the timing of consumer choice by having "waiting periods" before someone can buy insurance or by excluding "pre-existing conditions." However, this can cause people with chronic illness or high-risk dependents to be afraid to switch employers and is now limited by HIPAA. "Cream Skimming" (also called "Cherry Picking") happens when unusually low-cost people select an insurance plan. Cream skimming occurs when an insurer knows more about consumers' expected costs than the consumers themselves and uses marketing or plan design to enroll a healthier-than-usual population. For example, a plan that offers excellent obstetric care but poor oncology care will probably attract a healthier population than one that offers the opposite. A common criticism of low-cost health plans is that they keep their costs low by enrolling healthier people (or encouraging unhealthy people to leave the plan) rather than by treating their enrollees more efficiently.
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