Adverse Selection
Adverse selection is an insurance phenomenon where higher-risk individuals are more likely to purchase insurance than lower-risk individuals, creating an imbalanced risk pool that can lead to increased premiums and potential market instability.
Exam Tip
Adverse selection = PRE-contract problem. Higher-risk individuals seek insurance more. Underwriting and risk classification are key defenses. Moral hazard = POST-contract behavior change!
What is Adverse Selection?
Adverse selection occurs when there is asymmetric information between insurance buyers and sellers. People who know they have higher health risks or greater likelihood of filing claims are more motivated to buy insurance, while healthier, lower-risk individuals may opt out or purchase less coverage.
How Adverse Selection Works
| Stage | What Happens |
|---|---|
| Information Asymmetry | Applicants know more about their risk than insurers |
| Self-Selection | Higher-risk individuals seek more coverage |
| Risk Pool Imbalance | Pool becomes weighted toward high-risk insureds |
| Premium Increases | Insurers raise rates to cover higher claims |
| Death Spiral | Healthy people drop coverage, further raising premiums |
Adverse Selection vs. Moral Hazard
| Concept | Timing | Description |
|---|---|---|
| Adverse Selection | Before contract | High-risk buyers seek insurance more than low-risk |
| Moral Hazard | After contract | Insured takes more risks because they have coverage |
Examples of Adverse Selection
| Insurance Type | Example |
|---|---|
| Life Insurance | Person with terminal illness applies for coverage |
| Health Insurance | Individual with chronic condition enrolls during open enrollment |
| Auto Insurance | Reckless driver seeks comprehensive coverage |
| Disability Insurance | Person in dangerous occupation buys maximum benefits |
How Insurers Combat Adverse Selection
| Method | Description |
|---|---|
| Underwriting | Assess risk through applications, medical exams |
| Risk Classification | Charge different premiums based on risk factors |
| Waiting Periods | Delay coverage for pre-existing conditions |
| Contestability Period | 2-year window to investigate misrepresentations |
| Guaranteed Issue Limits | Cap coverage amounts without underwriting |
| Group Insurance | Spread risk across diverse employee populations |
The Premium Spiral (Death Spiral)
- Adverse selection increases average risk in the pool
- Insurer raises premiums to cover higher claims
- Healthier individuals drop coverage (too expensive)
- Risk pool becomes even more adverse
- Premiums rise again, more healthy people leave
- Market may collapse or become unaffordable
Regulatory Solutions
- Individual Mandate - Requires everyone to have coverage (e.g., ACA)
- Guaranteed Issue - Insurers must accept all applicants
- Community Rating - Limits premium variation by health status
- Risk Adjustment - Transfers funds between insurers based on enrollee risk
Exam Alert
Adverse selection is a PRE-CONTRACT problem caused by asymmetric information. Higher-risk applicants are more likely to seek coverage than lower-risk applicants. Key defenses include underwriting, risk classification, and waiting periods. Don't confuse with moral hazard (post-contract behavior change)!
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Related Terms
Underwriting
InsuranceUnderwriting is the process by which an insurance company evaluates risk and determines whether to accept an application for coverage and at what premium rate.
Moral Hazard
InsuranceMoral hazard is an increased risk of loss due to dishonesty or character defects of the insured, such as intentionally causing damage to collect insurance proceeds or filing fraudulent claims.