insurance

Adverse Selection

A situation where individuals with higher risk are more likely to purchase insurance than those with lower risk, creating an imbalanced risk pool. This occurs when people have more information about their own risk level than the insurance company does, leading to potentially unprofitable situations for insurers.

Example

“The insurance company experienced adverse selection when healthy young adults opted out of the health plan while older, sicker individuals enrolled in large numbers, driving up claims costs.”

Memory Tip

Think 'Adverse Selection = Attracting Risky Customers' - the insurance attracts more people who are likely to file claims.

Why It Matters

Adverse selection can lead to higher premiums for everyone as insurance companies adjust rates to cover increased claims from high-risk individuals. Understanding this concept helps explain why insurers require medical exams, ask detailed questions, and sometimes exclude certain conditions from coverage.

Common Misconception

People often think adverse selection is just about sick people buying health insurance, but it applies to all insurance types. Many also believe it's about people lying to insurers, when it's actually about people having better knowledge of their own risks and making rational decisions based on that information.

In Practice

A life insurance company offers a new policy without requiring medical exams, hoping to attract healthy customers with convenience. However, people with known health issues are more motivated to apply since they can get coverage without revealing their conditions. If 60% of applicants have undisclosed health problems compared to 20% in the general population, the company might face $2 million in unexpected claims on policies where they only collected $800,000 in premiums, forcing them to raise rates or require medical exams.

Etymology

The term combines 'adverse' (harmful or unfavorable) with 'selection' (the process of choosing). It originated in economic theory in the 1970s, particularly through economist George Akerlof's work on information asymmetry, though the concept was observed in insurance much earlier.

Common Misspellings

Adverse SelctionAdvers SelectionAdverse SelectonAdverce Selection

Related Terms

Risk Pool moral hazard underwriting

More in insurance

Other insurance terms you should know

deductibleThe amount you pay out-of-pocket before your insurance begin…insurance premiumThe amount paid periodically to an insurance company in exch…deductibleThe amount a policyholder must pay out of pocket before insu…copayA fixed amount paid by an insured person at the time of a me…coinsuranceA cost-sharing arrangement where the insured pays a percenta…out-of-pocket maximumThe most an insured person will pay for covered healthcare s…