Question

What is Adverse Selection in Insurance? Suggest two general ways of ameliorating Adverse Selection in Insurance.

Answer 1

Adverse selection refers generally to a situation in which sellers have information that buyers do not have, or vice versa, about some aspect of product quality—in other words, it is a case where asymmetric information is exploited. Asymmetric information, also called information failure, happens when one party to a transaction has greater material knowledge than the other party.

Typically, the more knowledgeable party is the seller. Symmetric information is when both parties have equal knowledge.

In the case of insurance, adverse selection is the tendency of those in dangerous jobs or high-risk lifestyles to purchase products like life insurance. In these cases, it is the buyer who actually has more knowledge (e.g., about their health). To fight adverse selection, insurance companies reduce exposure to large claims by limiting coverage or raising premiums.

Adverse selection occurs when one party in a negotiation has relevant information the other party lacks. The asymmetry of information often leads to making bad decisions, such as doing more business with less-profitable or riskier market segments.

In the case of insurance, avoiding adverse selection requires identifying groups of people more at risk than the general population and charging them more money. For example, life insurance companies go through underwriting when evaluating whether to give an applicant a policy and what premium to charge.

General ways of ameliorating Adverse Selection in Insurance:

1) Insurance companies need ways to identify groups that are at greater risk of loss. One way of doing this is the insurance questionnaire. You may have wondered why the insurance company asks you so many questions before you buy an insurance policy. Here is why the insurance company asks you so many questions—it is trying to properly classify the risk and determine the appropriate insurance rate for the exposure to loss. The insurance company uses the information you provide on your insurance application to help underwrite the policy.

If an insurance company does determine that you intentionally gave false or inaccurate information on your insurance application, it can cancel your policy or increase your insurance premium. In medical insurance, applicants may be asked to undergo a physical examination so that the insurance company can identify “high-risk” individuals and charge the appropriate insurance premium.

2)It is important to be truthful in any questions asked of you by the insurance company when purchasing a policy. The insurance company uses this information to accurately classify risk and assign the proper policy coverage and premium. If you are not truthful in your disclosures to the insurance company, this is called misrepresentation and could lead to your policy being cancelled or an increase in your insurance premium. Dishonestly on an insurance application can also mean that the insurance company does not have to pay your claim because of the “utmost good faith” doctrine which says that the insurance applicant must answer all questions truthfully and completely.