Question

What is the adverse selection problem? How does adverse selection affect the profitable management of an insurance company?

Answer 1

Adverse selection problem happens due to asymmetry in the information where buyer and sellers both have different information. Generally buyers are better informed in adverse selection problem and due to that they make it difficult for buyers to make profit by usual market practices.

For an insurance company, the adverse selection problem arises due to the fact that buyers of insurance policies need it more than the others who do not buy insurance policies. Therefore premium calculated based average population (both healthy and unhealthy) is not true representative of appropriate premium which should be charged from the customers. There are chances that proportionately larger number of high-risk customers may take insurance and the revenue received through premium by them is not sufficient to cover the liabilities incurred from these insurances and insurance company can make a huge loss. Therefore this adverse selection problem can affect the profitable management of insurance companies.