What is Adverse Selection?
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 the case of insurance, adverse selection is the tendency of those in dangerous jobs or high-risk lifestyles to purchase life insurance. To fight adverse selection, insurance companies reduce exposure to large claims by limiting coverage or raising premiums.
Breaking Down Adverse Selection
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.
Adverse Selection in the Marketplace
A seller may have better information than a buyer about products and services being offered, putting the buyer at a disadvantage in the transaction. For example, a company’s managers may more willingly issue shares when they know the share price is overvalued compared to the real value; buyers can end up buying overvalued shares and lose money. In the secondhand car market, a seller may know about a vehicle’s defect and charge the buyer more without disclosing the issue.
Adverse Selection in Insurance
Because of adverse selection, insurers find that high-risk people are more willing to take out and pay greater premiums for policies. If the company charges an average price but only high-risk consumers buy, the company takes a financial loss by paying out more benefits or claims. However, by increasing premiums for high-risk policyholders, the company has more money with which to pay those benefits. For example, a life insurance company charges higher premiums for race car drivers. A car insurance company charges more for customers living in high crime areas. A health insurance company charges higher premiums for customers who smoke. In contrast, customers who do not engage in risky behaviors are less likely to pay for insurance due to increasing policy costs.
Solutions to Adverse Selection
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. Underwriters typically evaluate an applicant’s height, weight, current health, medical history, family history, occupation, hobbies, driving record, and lifestyle risks such as smoking; all these issues impact an applicant’s health and the company’s potential for paying a claim. The insurance company then determines whether to give the applicant a policy and what premium to charge for taking on that risk.