Adverse Selection - Insurance

Insurance

The term adverse selection was originally used in insurance. It describes a situation wherein an individual's demand for insurance (the propensity to buy insurance and/or the quantity purchased) is positively correlated with the individual's risk of loss (like higher risks buy more insurance), and the insurer is unable to allow for this correlation in the price of insurance. This may be because of private information known only to the individual (information asymmetry), or because of regulations or social norms which prevent the insurer from using certain categories of known information to set prices (for example, the insurer may be prohibited from using such information as gender, ethnic origin, genetic test results, or preexisting medical conditions, the last of which amount to a 100% risk of the losses associated with the treatment of that condition). The latter scenario is sometimes referred to as "regulatory adverse selection."

The potentially adverse nature of this phenomenon can be illustrated by the link between smoking status and mortality. Non-smokers, on average, are more likely to live longer, while smokers, on average, are more likely to die younger. If insurers do not vary prices for life insurance according to smoking status, life insurance will be a better buy for smokers than for non-smokers. So smokers may be more likely to buy insurance, or may tend to buy larger amounts, than non-smokers, thereby raising the average mortality of the combined policyholder group above that of the general population. From the insurer's viewpoint, the higher mortality of the group which selects to buy insurance is adverse. The insurer raises the price of insurance accordingly, and as a consequence, non-smokers may be less likely to buy insurance (or may buy smaller amounts) than they would buy at a lower price reflective of their lower risk. The reduction in insurance purchases by non-smokers is also adverse from the insurer's viewpoint, and perhaps also from a public policy viewpoint.

Furthermore, if there is a range of increasing risk categories in the population, the increase in the insurance price because of adverse selection may lead the lowest remaining risks to cancel or not renew their insurance. This promotes a further increase in price, and hence the lowest remaining risks cancel their insurance, leading to a further price increase, and so on. Eventually this "adverse selection spiral" might, in theory, lead to the collapse of the insurance market.

To counter the effects of adverse selection, insurers (to the extent that laws permit) ask a range of questions and may request medical or other reports on individuals who apply to buy insurance so that the price quoted can be varied accordingly, and any unreasonably high or unpredictable risks rejected. This risk selection process is known as underwriting. In many countries, insurance law incorporates an "utmost good faith" or uberrima fides doctrine, which requires potential customers to answer any underwriting questions asked by the insurer fully and honestly; if they fail to do this, the insurer may later refuse to pay claims.

Whilst adverse selection in theory seems an obvious and inevitable consequence of economic incentives, empirical evidence is mixed. Several studies investigating correlations between risk and insurance purchase have failed to show the predicted positive correlation for life insurance, auto insurance, and health insurance. On the other hand, "positive" test results for adverse selection have been reported in health insurance, long-term care insurance and annuity markets. These "positive" results tend to be based on demonstrating more subtle relationships between risk and purchasing behavior (such as between mortality and whether the customer chooses a life annuity which is fixed or inflation-linked), rather than simple correlations of risk and quantity purchased.

One reason why adverse selection may be muted in practice may be that insurers' underwriting is largely effective. Another possible reason is the negative correlation between risk aversion (such as the willingness to purchase insurance) and risk level (estimated ex ante based on observation of the ex post occurrence rate of observed claims) in the population: if risk aversion is higher amongst lower risk customers, such that persons less likely to engage in risk-increasing behavior are more likely to engage in risk-decreasing behavior (to take affirmative steps to reduce risk), adverse selection can be reduced or even reversed, leading to "propitious" or "advantageous" selection.

For example, there is evidence that smokers are more willing to do risky jobs than non-smokers, and this greater willingness to accept risk might reduce insurance purchase by smokers. From a public policy viewpoint, some adverse selection can also be advantageous because it may lead to a higher fraction of total losses for the whole population being covered by insurance than if there were no adverse selection.

In studies of health insurance, an individual mandate that requires people to either purchase plans or face a penalty is cited as a way out of the adverse selection problem by broadening the risk pool. Mandates, like all insurance, increase moral hazard.