Loading the player...

What is 'Adverse Selection'

Adverse selection refers generally to a situation where 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 get 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.

  1. Insurance Premium

    An insurance premium is the amount of money that an individual ...
  2. Insurance Coverage

    Insurance coverage is the amount of risk or liability covered ...
  3. Classified Insurance

    Insurance coverage provided to a policyholder that is considered ...
  4. Personal Lines Insurance

    Personal lines insurance includes property and casualty insurance ...
  5. Life Insurance

    A protection against the loss of income that would result if ...
  6. Insurance

    Insurance is a contract (policy) in which an insurer indemnifies ...
Related Articles
  1. Insurance

    What is Adverse Selection in the Insurance Industry?

    Adverse selection impacts the markets for health insurance and automobile insurance, but interfering with actuarial work has consequences.
  2. Insurance

    Bundle Your Insurance For Big Savings

    Bundling your insurance can save you money and time. Read on to see how get the most out of multiline insurance discounts.
  3. Financial Advisor

    Who Should Buy a Guaranteed Issue Life Insurance Policy?

    Guaranteed issue life insurance policies have added costs and reduced benefits that make them suitable for only a limited pool of buyers.
  4. Investing

    Methods of Handling Risk: A Quick Guide

    Discover the five methods to manage pure risk, and learn how they can be implemented to mitigate risk with health and life insurance.
  5. Insurance

    What to Expect When Applying for Life Insurance

    Before jumping into a life insurance policy, learn what decisions you have to make and what you can do to reduce your premiums before you apply.
  6. Insurance

    How To Invest In Insurance Companies

    Knowing the special circumstances that insurance companies operate under helps in evaluating whether or not a listed insurance company is a good investment and whether the economic environment ...
  7. Insurance

    Can I Get Life Insurance?

    Find out what you can do to get the coverage you need for the right price.
  8. Insurance

    4 Things That Keep You From Getting Life Insurance

    We look at four common reasons people give for not applying for life insurance, and see if they're legitimate.
  1. How does adverse selection affect insurance premiums?

    Find out what causes adverse selection in the insurance market and why it drives up premiums for all policyholders. Read Answer >>
  2. Moral Hazard vs Adverse Selection

    Learn about the differences between moral hazard and adverse selection and how the two processes create undesired results. Read Answer >>
  3. In what ways does government regulation impact the insurance sector?

    See how government regulation of the insurance sector leads to higher prices, more risk and a system where the consumer has ... Read Answer >>
  4. What is the main business model for insurance companies?

    Read about the most important components of an insurance company business model, such as risk pricing, investing and claims ... Read Answer >>
Hot Definitions
  1. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
  2. Standard Deviation

    A measure of the dispersion of a set of data from its mean, calculated as the square root of the variance. The more spread ...
  3. Entrepreneur

    An entrepreneur is an individual who founds and runs a small business and assumes all the risk and reward of the venture.
  4. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  5. Perfect Competition

    Pure or perfect competition is a theoretical market structure in which a number of criteria such as perfect information and ...
  6. Compound Interest

    Compound Interest is interest calculated on the initial principal and also on the accumulated interest of previous periods ...
Trading Center