PHI 101: Why Private Insurance Companies Don’t Spread Risk

Most insurers try to get only healthy members.

• Reject sick (high-risk) people
• Exclude coverage of pre-existing conditions
• Charge people more if they are high-risk
• Design benefits so that people with costly conditions either do not want to join or must pay high costs for their care

The healthier their members, the higher their profits.

All insurance spreads some risk, but insurers try to avoid risk and keep people with costly conditions or predisposed to them getting covered in order to maximize their profits. Individuals who are healthy in turn sometimes go without insurance especially if they are young, assuming that they will not need health care and saving money on insurance premiums. This leads to what is called adverse selection. If more people in the pool are sick, the higher the “average” cost of coverage will be.

To discourage people from waiting to get coverage until they are sick, insurers medically underwrite policies—charging a lot more for people who are sick or who are likely to become sick or refuse to sell policies to high-risk applicants (for example, people with diabetes.)

If states allow it, insurers also will avoid covering pre-existing conditions—health problems people had before they bought the policy.

Or, if states allow it, insurers will charge premiums based on an individual’s likely health care needs, called risk-based rating. Under risk-based rating, somebody who already has diabetes would be charged more than somebody with no health problems. The difference in premiums would reflect the difference in expected health care costs for each policyholder. Some states require community rating, the opposite of risk-based rating. With community rating, each policyholder’s premium is based on the average cost of the entire pool—healthy and sick mixed together.

Insurers will also design their benefit package to try to avoid people with costly conditions. Policies that don’t cover maternity, mental health, or prescription drugs will be less attractive to people who need such care. Similarly, policies with high deductibles and other cost sharing may be more attractive to healthy people than to sick patients.

Insurers want a healthier-than-average risk pool. That’s called “risk selection” or “cherry picking”. An insurer can make bigger profits if its risk pool is healthier than the competition’s. That’s why it can be very hard for individuals who need costly health care to get or keep insurance.

The thousands of different insurance plans around the country, fragment the risk pool. The larger the risk pool, the better its ability to spread the risk. The smaller the risk pool, the more expensive insurance becomes.

So risk spreading in health insurance involves tradeoffs. Coverage that is sold to people when they are sick and that covers all the care that sick people will need, tends to be more expensive. Conversely, inexpensive coverage is likely to not be sold to people who are sick and is likely to provide far less coverage for health care when it is needed.