Adverse selection is a term that is mostly applied in the insurance industry to refer to a phenomenon wherein the insurer is confronted with the probability of loss due to risk that was not factored in at the time of sale. This happens in the event of an asymmetrical movement of information between the insured and the insurer. Adverse selection occurs when the insured deliberately decides to hide certain pertinent information from the insurer. The information may be very critical in nature as they help in ascertaining the risk profile of the insured party and also assist in determining the correct premiums.
Non-disclosure of the information which affects the life of the insured can lead to confusion during the calculation of premiums, thus loss to the insurance company since the insurer will not find it easy to conduct a prudent asset liability management owing to payment of more claims than the premiums received. Thus, insurers try to encourage people who are healthier to buy coverage unlike those with pre-existing conditions.
In order to counter the impacts of adverse selection, insurance companies today tend to ask a variety of questions and may even request medical and other reports on people who apply to purchase insurance so that the price that is quoted can be accordingly varied, and highly unpredictable risks eliminated. This process of selection of risks is known as underwriting. In many countries, insurance laws incorporate the doctrine of Utmost good faith which requires that if the person who is seeking insurance cover fails to answer the underwriting questions honestly, the insurer may refuse to pay claims later on.
There are quite a number of reasons why adverse selection might be muted in practice. One of them is that the underwriting of insurers is largely effective. Another possible reason is the negative correlation between risk aversions like the willingness to buy insurance. It can be simply put that, if risk aversion is higher among lower risk customers, to an extent that people who are less likely to take part in risk-increasing behavior are more likely to engage in risk-decreasing behavior, adverse selection can be reduced or even reversed.
An ideal example can be like, there is evidence that smokers are often more willing to undertake risky jobs compared to non-smokers. This greater willingness to accept risk might lower the chances of insurance purchase by smokers. From the viewpoint of a public policy, certain adverse selection can also be advantageous because it may lead to a higher fraction of total losses for the entire population that is being covered by insurance than if adverse selection never existed.
Even though adverse selection theoretically seems to be an obvious and inevitable consequence of economic incentives, the empirical evidence is mixed. A number of studies investigating the correlations that exist between risk and insurance purchase have not been able to show predicted positive correlation for life insurance, health insurance and auto insurance.
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