Adverse Selection in Private, Stand-Alone Drug Plans and Techniques to Reduce It

Private insurance companies currently offer a variety of health insurance products for individuals. In most cases, these products are underwritten, whereby insurers may charge higher premiums to people with expensive health needs or, alternatively, deny coverage altogether. Despite this underwriting ability, no insurance companies now offer stand-alone prescription drug coverage. Why is this? One major factor may be that the cost of offering and administering a drug-only product is quite expensive. Consequently, the high premiums that insurers would need to charge would discourage enrollment of people with relatively low drug expenses. Thus, insurers would find it difficult to offer an attractive product.
The problem stems from adverse selection, whereby those who anticipate moderately high drug costs are more interested in purchasing drug coverage, particularly generous drug coverage, than those who anticipate low costs. Because future annual prescription drug costs generally are easier for an individual to calculate and predict than total health care spending, adverse selection is of greater concern for drug-only plans than for plans covering a broader range of health care services. Further, the risks associated with a stand-alone benefit cannot be spread across a range of categories (as is usually the case for health insurance); nor can health and drug costs be counterbalanced.
This brief explores how adverse selection may impair the implementation of a drug benefit that relies on private, drug-only plans, and examines ways the federal government would need to intervene to mitigate the consequential problems. To make the drug benefit work for beneficiaries, plans need to compete on quality rather than on attracting the least expensive enrollees. This brief uses as examples the stand-alone drug benefits proposed in the 2003 bills that passed the House and the Senate.