Adverse selection is the social occurrence where a person with a higher risk seeks greater insurance coverage than those who are with less risk.
To mitigate the risk of adverse selection, insurance companies reduce the risk of high claims by limiting insurance coverage or by raising premiums for high-risk policyholders.
Adverse selection occurs in the situation when a seller has information that buyers do not have or vice versa.
In the case of insurance, the buyer has more knowledge than the seller (Insurance company).
Suppose that you are a person who smokes and you know that you have high mortality compared to a normal person. If the insurance company uses the same price for all insureds.
You (and others with a high mortality risk) will see the insurance as good value, because your expected loss may higher than the premium. Therefore you and lots of people like you will take insurance. This clearly indicates that the insurance company will attract more high-risk individuals.
The rest population (with below-average risks) will feel that insurance rates are expensive, some may not take out insurance.
If this continues for a long time, the company will sell the policies to high-risk individuals, which leads to its claim experience above average.
To reduce the problem of Adverse selection, all insurance companies try to collect as many as possible details they can collect from the potential policyholders to predict the riskiness of any person.
Written by: Kalpesh Agrawal