Pitfalls of Health Plan Adverse Selection

Individual Adverse Selection

Essentially this happens on your employee benefit plans when they are voluntary in nature (when they require an employee to pay portion of the premiums), and is caused from the rational purchasing of these benefits by employees. The theory is that employees will elect to pay an amount of money for benefits (say $100 per month) only if they expect to get more than $100 of value out of the plan. It is important to understand how this works when you are going through your benefit renewal process.

The 80 / 20 rule works well in helping to explain it. 80% of your employees are causing only 20% of the claims experience, while 20% are causing the other 80% – and thus they are responsible for 80% of your costs. Think about this as a continuum from the most healthy to the sickest person on your group (the healthy get the least amount of benefit, while the sick get significant amounts of benefit).

So here comes your renewal, and it is 20%+. To curb the expenses to the company, you decide to pass along part of the increase in the form of increase employee deductions. As this happens over time, you should expect to price your healthy people off of your plan. Take your single, healthy employee – you can charge him an amount that will make him stay away from your plan. On the other hand, consider your employee that has significant health issues – you cannot charge them enough to get them off of your plan.

The reason this can be detrimental is that if this model were to persist through time, eventually you would end up with only the sickest people on your plan. You would be offering a benefit to only 20% of your employee population & the cost would be 80% of what it was originally. This result would be catastrophic, and thus is the reason that it pays to respect the power of adverse selection.

Location Adverse Selection

Many larger employers and employers of certain types (who have grown over time due to acquisition) can experience a whole different type of adverse selection in their plans, called location specific adverse selection. Many business models will lend themselves to this additional risk possibility. This comes from the fact that not every entity/location participates in your benefit plan.

This is an example of how this comes about: let’s assume that a company is just starting up & you were taking over 5 locations. Their employee only medical rates per month were ($225, $250, $300, $375, $425). As you know, the reason that each of them are being charged different amounts is because of the claims risk in each group – the group paying $425 per month is paying that amount because they have medical claims which substantiate that high of a premium.

After underwriting, we have a carrier that comes to us with a rate that pulls all of these people together & it is a rate of $295 per month. The problem with this is that the people paying $225 & $250 per month are not going to want to participate, while the others will want to do so. If this is allowed, then you will be left with a plan priced at $295 when it should have been priced higher (since the $300, $375 & $425 were the ones who participated).

You probably guessed what will happen come renewal time – it will be a big one. Let’s assume it goes to $390 per month – now we will likely lose the $300 & $375 locations if we allow them to opt in & out. The end result is the same as that of individual adverse selection.

There are a myriad of ways to correct for this issue, but the main thing that any organization can do is to recognize the issue before it becomes a major problem.

Mark Combs (CLU, ChFC, CFP®, RHU, REBC, CFA®)

Mark is a Vice-President, part owner of Horne/Guest Employee Benefits http://www.horneguest.com – one of the largest employee benefit advisory firms in South Carolina. Horne/Guest is also a Charter Member of United Benefit Advisors, which is the 3rd largest employee benefit advisory firm in the US. You can learn more about UBA via Google. Mark is a graduate of Wofford College, with two undergraduate degrees (Bachelor of Arts in Political Economy and Philosophy & Bachelor of Science in Economics). He entered the individual financial services field directly out of college as a Certified Financial Planner® with John Hancock Financial, where he was selected as “Rookie of The Year” in 1998.

Mark began working in the employee benefits arena with Marsh & McLennan Companies, specializing in large employee groups. Mark holds 6 professional designations & was honored in 2003 with the Distinguished Educational Achievement Award from the American College.

As a veteran in the employee benefit industry, he brings tons of professional knowledge to the table. As a specialty, Mark creates processes that help employers save money while maximizing the value of their employer-employee relationships. His vast array of expertise allows him to automate processes, and system applications to make life easier for his clients and their employees.

Mark also has a tremendous amount of expertise in creating Employer Wellness Programs, and is the author of The PlanWELL Method Wellness System. Applying Wellness and Disease Management Tactics effectively promises to be the biggest trend in healthcare over the next 10 years. The PlanWELL Method teaches employers the fundamentals of a well functioning, data-driven corporate wellness program. These type of programs consistently render return on investment of 5 to 10+ times initial investment. For more information, you can visit http://www.planwellmethod.com