Question

1. Adverse selection can lead to collapse of health insurance market through adverse selection death spiral. Although adverse selection can be observed in any insurance market, we do not observe adverse selection in many cases. Name reasons why adverse selection may not occur in real markets. Explain each reason

Answer 1

                           Adverse selection in the health insurance market refers to the phenomenon where the higher-risk sick individuals who have greater coverage needs would resort to purchasing the health insurance whereas low-risk healthy individuals would delay or decides to abstain from it. The death spiral refers to a condition where the structure of the insurance plan would change and the premium would rise rapidly owing to changes in the population being covered under the health insurance. Here, as high risk individuals are covered more due to adverse selection, we can see that many unforeseen deaths would occur which may cause the insurance firm to give more amount than the premium that is already paid and this may lead to increasing the premium for the existing low-risk category of people who are a part of the market as much of such population have decided to opt out of the market and remain uninsured.

                        The adverse selection would have several negative effects on the insurance firm and may lead to the failure of the firm in the process. As much of the individuals who are covered under the process are high-risk individuals, the insurance firm may have to settle more number of claims which would lead to increase in the premium for existing policy holders and thus may force the newer insurants to opt out or not choose the insurance firm. But the situation is less seen in the real insurance process. Most of the insurance firms have strict checks before an insurance is being created. The checks would make sure that people who are of higher risk are not being made a part of the policy. Thus, those who have serious issues would have to specify them in the checks and hence would have to opt out of the insurance selection. This forms the major reason why there is less such case in the real market. Moreover, those who file wrong informations would have to face serious issues in the future and thus the new ones would have to provide right information which would help the firm to identify such cases and thus make sure that the insurance market doesn’t contain such individuals.