Examples of adverse selection in the insurance industry
Adverse selection generally refers to any situation in which a party to a contract or negotiation, such as a seller, has information relevant to the contract or negotiation that the corresponding party, such as a buyer, does not have. Usually, the most informed party is the seller. Adverse selection occurs when this asymmetric information is exploited, leading the party lacking relevant knowledge to make decisions that adversely affect them.
In the insurance industry, adverse selection refers to situations in which an insurance company extends insurance coverage to an applicant whose actual risk is significantly greater than the risk known to the insurance company. The insurance company is adversely affected by providing coverage at a cost that does not accurately reflect its actual exposure to risk.
Key points to remember
- Anti-selection in the insurance industry means that an applicant obtains insurance at a cost lower than their true level of risk.
- Someone with a nicotine addiction who obtains insurance at the same rate as a person without nicotine addiction is an example of adverse selection of insurance.
- Insurance companies have three options to protect against adverse selection, including accurately identifying risk factors, setting up an information verification system, and capping coverage.
Insurance coverage and premiums
An insurance company provides insurance coverage based on identified risk variables, such as the policyholder’s age, general health, profession and lifestyle. The policyholder receives coverage within the limits of defined parameters in exchange for the payment of an insurance premium, a periodic cost based on the risk assessment of the policyholder’s insurance company in terms of probability that a policyholder will file a claim and the probable dollar amount of a claim filed.
Higher premiums are charged to those at higher risk. For example, someone who works as a race car driver has to pay considerably higher life or health insurance premiums than someone who works as an accountant.
Examples of adverse selection
Adverse selection for insurers occurs when a claimant manages to secure coverage at lower premiums than the insurance company would charge if it were aware of the real risk to the claimant, usually because the claimant is withholding relevant information. or provides false information that thwarts the effectiveness of the insurance company’s risk assessment system.
The potential penalties for knowingly giving false information about an insurance claim range from misdemeanors to state and federal crimes, but the practice does occur nonetheless. A prime example of adverse selection for life or health insurance coverage is a nicotine dependent person who succeeds in obtaining insurance coverage as a person without nicotine addiction. Smoking is a key risk factor identified for life insurance or health insurance, so a person who uses nicotine products must pay higher premiums to get the same level of coverage as they do. ‘a person who does not use one. By hiding his addiction to a substance, an applicant causes the insurance company to make decisions on coverage or premium costs that are unfavorable to the management of financial risk by the insurance company.
An example of adverse selection in the provision of auto insurance is a situation where the applicant obtains insurance coverage based on the provision of a residence address in a very low crime area while the applicant is actually living. in an area with a very high crime rate. . Obviously, the risk of the applicant’s vehicle being stolen, vandalized or otherwise damaged when regularly parked in a high crime area is significantly higher than if the vehicle was regularly parked in a low crime area. Antiselection can occur on a smaller scale if an applicant states that the vehicle is parked in a garage every night when it is in fact parked on a busy street.
Insurance companies against adverse selection
Since adverse selection exposes insurance companies to high risks for which they do not receive appropriate compensation in the form of premiums, it is essential that insurance companies take all possible measures to avoid selection situations. opposing.
There are three main steps insurance companies can take to protect themselves from adverse selection. The first is the precise identification and quantification of risk factors, such as lifestyle choices that increase or decrease an applicant’s level of risk. The second is to have a well-functioning system in place to verify the information provided by insurance applicants. A third step is to place limits or caps on coverage, referred to in the industry as aggregate liability limits, which cap the insurance company’s total financial risk exposure. Insurance companies institute standardized systems and practices to implement protection against adverse selection in all three areas.