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.