Question

A firm purchases a life insurance contract from a sick person, then collects the payout when he dies. These types of contracts are called viatical settlements. It is the sale of a policy owner's existing life insurance policy to a third party owner for more than its cash surrender value but less than the net death benefit (Wikipedia). These markets are also referred to as reverse insurance markets. Firms have an incentive to enter into such settlements if they expect the person whose life insurance policy is being purchased to die relatively soon. If the person dies, the firm gets to collect the death benefit. Answer the following question below that pertain to viatical settlement markets:

Q. Would this type of a market suffer adverse selection problems? Explain your answer clearly. [Hint: Students are advised to look into BHT text or do some Google research on this to be able to answer this question properly. There is the theoretical explanation and then there is what actually happened in the market]

Answer 1

Adverse Selection problem in economic simply refers to the fact that when two people engage in a contract, one party may have higher knowledge than the other about elements that the other party may not be aware off.

In the financial sector, this happens when those taking loans are of higher knowledge that they may not be able to pay off their debt, as they are not performing well at their jobs. While bank may look over your previous records, such as previous payments, income tax details etc, but they still may not be aware of problems which the person may be facing at work.

In the current scenario, reverse insurance or the practice of purchasing the existing insurance policy cover of a person and giving him a lesser amount of cash today may be considered as an adverse selection problem. This is because often insurance contracts themselves fail when people do not tell about their previous ailments to insurance companies. Further, they may be aware of the fact that they are healthier than they may seem to be and may still prefer to pay higher insurance premiums for a higher pay out by insurance companies and thereby improving their chances of getting better payments for reverse insurance contracts.

Thus, reverse insurance contracts are indeed subject to the economic problem of adverse selection, whereby they may experience a loss if they fall short of getting adequate information about a person’s health, their previous history of contracts with the insurance company and the fact that they may be inflating their insurance policies is also to be critically evaluated.

In economics one way of reducing your adverse selection problem, is to engage in adequate research of the market to identify these problems and to take corrective actions prior to entering these types of contracts respectively.

Please feel free to ask your doubts in the comments section.