How to Reduce the Risk of Adverse Selection in a Cafeteria Plan

by Steve McDonnell Google

When your employer lets you create a custom benefit plan by selecting only the benefits you want and paying for them with flex credit dollars, you're enrolling in a "flexible benefits" or "cafeteria" plan. However, the problem of adverse selection arises if you and other employees select vision coverage because you have eye problems, and nobody without eye problems chooses the coverage. This would cause vision-insurance premiums to spiral up and may lead the employer to withdraw the coverage. This, however, is not the end of the story.

Group Health Insurance

When you sign up for healthcare benefits through your employer, you're participating in a group health insurance plan. Group insurance purports to keep insurance premiums lower by spreading the risk over a group of people that includes healthy individuals who have low or no claims and people with health problems who have higher claims. Premiums from the healthy people in the group help pay for the claims of the people who get sick.

Adverse Selection

When employees have greater flexibility to choose their benefits, they naturally select the benefits they anticipate using the most. Those who don't anticipate using a benefit might not select it at all. This can cause a disproportionate number of people with higher claims to choose certain benefits. The high claims raise the price of the insurance, which might further discourage those who aren't sure they need the benefit from selecting it. Ultimately, the high price can make the plan unaffordable for everyone.

Creating Representative Groups

The best way to reduce the risk of adverse selection is to make the group that chooses each benefit more representative of the group as a whole. Some states and insurance companies require that for companies where employees pay for a portion of their benefits at least 75 percent of eligible employees select a benefit in a cafeteria plan for the benefit to be offered. For companies where employees don't pay any premiums for coverage, most states require that they enroll every employee in every benefit plan they provide, regardless of whether an employee selects the benefit.

Requiring and Bundling Benefits

To make sure that every employee has at least basic coverage and to help avoid adverse selection, some companies require employees to accept a basic set of benefits. Their flex credits can then be used to select supplemental benefits, which tend to cost more because they're purchased by those who need them the most. Other companies bundle benefits to gain broader participation. For example, they may require that if you choose dental coverage, you must also choose vision coverage, even if you don't need it. Excluding part-time employees from benefit plans can also reduce adverse selection because some part-time employees work primarily because they need benefits.

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