Adverse Selection

If insurance is available at the same price to people facing widely varying risks, then those with the greatest risks are more likely to buy insurance. This adverse selection works to the detriment of insurers. Unchecked, it would make underwriting unprofitable.

Insurers protect themselves from adverse selection by attempting to measure risk and either charging more from the higher risks, or by refusing to cover them at all. For example, motor insurers charge higher premiums for cars and drivers that are statistically more likely to be involved in accidents. Medical insurers usually exclude pre-existing conditions (i.e. any illness that pre-dates the start of cover) from their cover in order to deter people from buying cover after a problem has been diagnosed.

In part, the problem of adverse selection is dealt with by the insurers’ attempts to measure risk, which is anyway necessary to setting premiums. However, this still leaves insurers with a significant problem in any circumstances where the insured may have more information than they do. This is why, unlike other contracts, insurance contacts are agreed uberrimae fides (in utmost good faith). This means that a persons (which includes organisations as well as people) taking out insurance are required to inform the insurer of all relevant information, not just what they are directly asked for.

In some countries, there are restrictions on what information insurers can gather, which can affect their ability to limit adverse selection. In the UK, life insurers cannot require applicants for cover below a threshold level to take genetic tests, even though it is fairly easy for people to have tests performed and conceal the results.

Adverse selection has similarities to moral hazard. Both change risks to insurers as a result of customer behaviour.

General Setup

Has two different meanings. In most cases, adverse refers to the theory of lemons with a “harmful” effect on the market. The second one is the “positive” incentives based on adverse selection, where a certain setup of requirements allows one to pick out appropriate candidates.

Harmful” Adverse selection

Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, risk management, and statistics. It refers to a market process in which undesired results occur when buyers and sellers have asymmetric information (access to different information); the “bad” customers are more likely to apply for the service. For example, a bank that sets one price for all of its checking account (current account) customers runs the risk of being adversely selected against by its low-balance, high-activity (and hence least profitable) customers. Two ways to model adverse selection are to employ signaling games and screening games.

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