What is adverse selection in the insurance industry?


One of the reasons most US state governments require all drivers to purchase auto insurance is to avoid the problem of “adverse selection,” or the process by which insurance customers buy them. more risky hunt less risky. If prices cannot adjust for individual risk, the more expensive insurance customers increase average premiums and make the purchase unprofitable for the less risky. Adverse selection is also the reason why American adults were, in fiscal year 2018, forced to purchase health insurance through Obamacare. There are economic arguments for such forced purchases, but concrete examples show that theory and practice often differ.

How Private Insurance Companies Protect Against Adverse Selection

Adverse selection is a matter of knowledge, probability and risk. In most situations, it is fairly easily overcome with differential pricing mechanisms. Suppose two different people apply for auto insurance with Allstate Corporation (NYSE: ALL). The first applicant is a 22-year-old man who commutes to and from work every day, has a history of speeding and has had accidents in the past. The second applicant is a 40-year-old mother who often takes public transportation to work and has not had a traffic ticket or an accident for over a decade.

From the insurer’s perspective, the first claimant is much riskier and much more likely to cost them money. The second claimant is a slight risk. To identify what is more risky, Allstate asks probing questions during the application process and also consults its actuarial tables; it turns out that men in their twenties are the most expensive to insure. Thus, Allstate can offset the additional risk by charging a higher premium to the first applicant.

Adverse selection and other solutions

Individuals vary in their need for risk protection and in their knowledge of risk and tolerance for risk. Insurance companies might have even less knowledge about individual circumstances. If insurance companies do not distinguish between high risk and low risk customers, meaning they are unable to perform effective actuarial processes, the average premium charged to a consumer can be so high that low risk clients are leaving the market.

If the differential pricing business model is not permitted or impractical, the other solution to adverse selection is to prevent low risk customers from exiting the market. This means forcing all individuals to purchase insurance, preventing insurance companies from collapsing under the cost of high risk payments. Indeed, low risk must subsidize high risk.

Example: adverse selection and affordable care law

The controversial Affordable Care Act of 2010, commonly known as ACA or Obamacare, required non-exempt adults in the United States to purchase health insurance. This is called the “individual mandate”. It was specially designed to prevent adverse selection from taking over the health insurance market after the ACA came into effect.

Two aspects of ACA make actuarial work more difficult, putting insurers and low-risk clients at a disadvantage. First, insurance companies must provide the same level of minimum coverage, called “essential health benefits”, to all applicants for insurance. Second, insurance premiums use community rating systems that make screening illegal based on many individual health considerations, such as medical history or gender. Instead, premiums are mostly set based on geography and age.

The ACA tackled these problems by obliging all companies with more than 50 employees to take out insurance and by imposing the individual mandate. Since it is quite possible but more legal to filter individuals based on risk, insurance companies receive subsidies for high risk consumers. The problem of adverse selection is created by the essential health benefits required and theoretically addressed by the individual mandate, although most exchanges experienced difficulties in July 2016. The individual mandate was abolished by the 2017 tax bill of the GOP, as of 2019.

Example: adverse selection and automobile insurance

On the surface, auto insurance works the same way as health insurance. When insurance companies can’t filter effectively, high-risk drivers can charge premiums for everyone. It can even cause low-risk drivers to decide not to drive, further hurting the profitability of insurers. This is the theory, but the practical reality is actually the opposite.

Mandatory auto insurance generally does not target low-risk drivers who might otherwise give up. Rather, it targets high-risk drivers and requires them to purchase insurance. Modern actuaries and insurance supervisors have no difficulty identifying risky drivers versus safe drivers, and many don’t want to cover high-risk drivers at a loss. For this reason, all states and the District of Columbia offer their own auto insurance policies in the “residual market” to subsidize high-risk drivers.


Martin E. Berry

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