Adverse selection generally refers to any situation where one party in 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. Typically, the more knowledgeable party is the seller. Adverse selection occurs when this asymmetric information is exploited, leading the party that lacks 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.
Key Takeaways
- Adverse selection in the insurance industry involves an applicant gaining insurance at a cost that is below their true level of risk.
- Someone with a nicotine dependency getting insurance at the same rate of someone without nicotine dependency is an example of insurance adverse selection.
- Insurance companies have three options for protecting against adverse selection, including accurately identifying risk factors, having a system for verifying information, and placing caps on coverage.
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 a 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.
Knowingly giving false information on an insurance application—which is a crime called insurance fraud—can lead to charges ranging from misdemeanors to felonies at the state and federal levels. Penalties can include tens of thousands of dollars in fines or even imprisonment.
Life or Health Insurance Example
A prime example of adverse selection in regard to life or health insurance coverage is someone with a nicotine dependency who successfully manages to obtain insurance coverage as a person without a nicotine dependency. Smoking is a key identified risk factor for life insurance or health insurance, so a person who uses nicotine products must pay higher premiums to obtain the same coverage level as someone who doesn't.
By concealing their substance dependence, 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.
Auto Insurance Example
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.
The best car insurance companies will fight adverse selection strategically in order to keep rates competitive.
How Insurance Companies Fight 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:
- Identify risk factors: The first action is the accurate identification and quantification of risk factors, such as lifestyle choices that increase or lessen an applicant's risk level.
- Verify applications: The second action is to have a well-functioning system in place to verify information provided by insurance applicants.
- Cap payouts: 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.
How Is Adverse Selection Different From Moral Hazard?
Adverse selection is when a "bad risk" buys insurance, while moral hazard is the reckless behavior of someone who is insured. Adverse selection happens before purchasing insurance, while moral hazard happens afterward.
How Does Easier Enrollment Affect Adverse Selection?
Some insurance companies worry that easier insurance enrollment will lead to increased adverse selection. However, during the Covid-19 pandemic, the government eased special enrollment rules, leading to an increase in enrollment; a study by the Commonwealth Fund found that despite increased enrollment, there was no increased adverse selection.
How Do Companies Prevent Adverse Selection?
Because adverse selection can affect a company's bottom line and its ability to pay claims, insurance companies take one or more steps to control it. They may take additional steps to verify applicants, cap payouts, and identify risk. In health insurance, these steps can also include risk adjustment and cost-sharing measures that split cost between the insured and the plan.
The Bottom Line
Adverse selection in insurance can put insurers at a disadvantage, creating an imbalance of sick members who file more claims vs. healthy people. This can affect the insurer's ability to control its risk and may result in higher premiums. To reduce adverse selection, insurance companies may impose additional verification on insurance applicants, cap the maximum payouts offered on claims, and work harder to identify increased risk factors.
