Adverse selection in insurance

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Adverse selection in insurance is a situation of market failure in an insurance market due to the problem of adverse selection: a situation of information asymmetry between the party being insured and the insuring party (insurer) in terms of knowledge about the probability about the eventuality being insured against.

The way this works in theory is as follows:

  • The seller of insurance has only general data about the average risk level (i.e., the average probability of a particular eventuality) and does not have any information about the risk level for each individual party being insured.
  • The buyer of insurance has a higher quality (more reliable) assessment of the probability of the eventuality being insured against.

As a result, the seller tends to price insurance premiums and terms of insurance keeping in mind the average risk level. Buyers of insurance whose self-assessed risk level is considerably lower than average find the insurance premium too high to purchase insurance, and hence drop out of the insurance market. In contrast, buyers of insurance whose self-assessed risk level is higher than average find the insurance a good deal. Thus, the low-risk buyers drop out of the market, causing the average risk level to rise which in turn leads to a rise in insurance premiums. This leads more people (for whom the earlier insurance premium was a reasonable deal) to drop out of the market. Proceeding this way, the insurance market gets smaller and smaller and fails to develop.

The key cause, as with other examples of adverse selection, is the asymmetry in information between the buyer and the seller. If both parties were equally in the dark, they would have similar assessments of the risk levels and therefore would agree on a fair premium.

Mitigating factors

Although adverse selection could occur in insurance markets, causing them to vanish over time, there are a number of possible mitigating factors:

  1. Actuarial data and screening technology helps overcome the information asymmetry: The insurance company, with access to lots of actuarial data about the profile of customers who tend to need to use insurance, can come up with filters and screening mechanisms that help identify high risk clients and charge them higher premiums (and similarly, offer lower premiums or better deals to low risk clients). Note that the insurance company must use statistical discrimination for much of this type of decision making.
  2. For information that is costly for the insurance company to collect for each individual, but that can be collected for the fraction of individuals who actually make insurance claims, the insurance company could include a disclosure requirement at the time of purchase of insurance, with violation of the disclosure requirement leading to a nullification of the insurance contract.
  3. The risk aversion that leads people to purchase insurance may also lead them to protect themselves against the eventualities insured against in other ways.
  4. Group insurance, where a large number of individuals who have come together for some other purpose (such as being in a workplace or country) are collectively insured, helps overcome the problem of low risk clients dropping out of the insurance pool.

The political economy of adverse selection

Adverse selection and moral hazard are two of the most commonly cited rationales for why insurance markets deserve special kinds of governmental regulations that are not necessary for other industries. However, often the political solutions to adverse selection are in fact trying to solve other problems and could end up exacerbating the adverse selection problem in so far as it exists.

Pre-existing conditions and coverage obligations

This is a form of regulation where insurance companies are required to not discriminate between customers on certain criteria while offering insurance plans. In other words, they are not permitted to refuse clients, or charge higher premiums to clients, who meet certain criteria.

Why this may be desired: This may be desired for various reasons of fairness or equity.

How this could exacerbate adverse selection: The use of higher premiums or the refusal of certain high risk clients indicates that the insurance company is able to estimate the risk levels of different clients, a partial solution to the adverse selection problem. By forbidding them from doing this, the adverse selection problem returns in full form.

Individual mandates

This is form of regulation where all individuals are required to buy insurance policies covering certain eventualities.

Rationale in terms of adverse selection: The idea is to prevent low risk customers from dropping out of the insurance pool, because if low risk customers drop out, the average risk level increases, leading to a rise in premiums.

What may happen in practice: Often, the focus of political groups is to ensure that high risk customers stay in the insurance pool, so that they avoid the high costs of an uninsured eventuality.