Adverse selection generally refers to any situation in which one party to a contract or negotiation, such as a seller, possesses information relevant to the contract or negotiation that the corresponding party, such as a buyer, does not have; this asymmetrical information leads the party lacking relevant knowledge to make decisions that cause it to suffer adverse effects. In the insurance industry, adverse selection refers to situations in which an insurance company extends insurance coverage to an applicant whose actual risk is substantially higher than the risk known by the insurance company. The insurance company suffers adverse effects by offering coverage at a cost that does not accurately reflect its actual risk exposure.

The Basics of Insurance Coverage and Premiums

An insurance company provides insurance coverage based on identified risk variables, such as the policyholder's age, general health condition, occupation and lifestyle. The policyholder receives coverage within set parameters in return for payment of an insurance premium, a periodic cost based on the insurance company's risk assessment of the policyholder in terms of the likelihood of the policyholder filing a claim and the probable dollar amount of a claim filed. Higher premiums are charged to higher-risk individuals. For example, a person who works as a racecar driver is charged substantially higher premiums for life or health insurance coverage than a person who works as an accountant.

Examples of Adverse Selection

Adverse selection for insurers occurs when an applicant manages to obtain coverage at lower premiums than the insurance company would charge if it were aware of the actual risk regarding the applicant, usually as a result of the applicant withholding relevant information or providing false information that thwarts the effectiveness of the insurance company's risk evaluation system. Potential penalties for knowingly giving false information on an insurance application range from misdemeanors to felonies on state and federal levels, but the practice occurs nonetheless.

A prime example of adverse selection in regard to life or health insurance coverage is a smoker who successfully manages to obtain insurance coverage as a nonsmoker. Smoking is a key identified risk factor for life insurance or health insurance, so a smoker must pay higher premiums to obtain the same coverage level as a nonsmoker. By concealing his behavioral choice to smoke, an applicant is leading the insurance company to make decisions on coverage or premium costs that are adverse to the insurance company's management of financial risk.

An example of adverse selection in the provision of auto insurance is a situation in which the applicant obtains insurance coverage based on providing a residence address in an area with a very low crime rate when the applicant actually lives in an area with a very high crime rate. Obviously, the risk of the applicant's vehicle being stolen, vandalized or otherwise damaged when regularly parked in a high-crime area is substantially greater than if the vehicle was regularly parked in a low-crime area. Adverse selection might occur on a smaller scale if an applicant states that the vehicle is parked in a garage every night when it is actually parked on a busy street.

How Insurance Companies Protect Themselves Against Adverse Selection

Since adverse selection exposes insurance companies to high amounts of risk for which they are not receiving appropriate compensation in the form of premiums, it is essential for insurance companies to take all the steps possible to avoid adverse selection situations. There are three principal actions that insurance companies can take to protect themselves from adverse selection. The first is accurate identification and quantification of risk factors, such as lifestyle choices that increase or lessen an applicant's risk level. The second is to have a well-functioning system in place to verify information provided by insurance applicants. A third step is to place limits, or ceilings, on coverage, referred to in the industry as aggregate limits of liability, that put a cap on the insurance company's total financial risk exposure. Insurance companies institute standard practices and systems to implement protection from adverse selection in all three of these areas.

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