Key Takeaways
- Adverse selection results when high-risk policyholders are more informed than insurers about their risk level.
- Insurers use risk assessments and verification to set accurate premiums and reduce adverse selection.
- Coverage limits help insurers manage their financial risk against unforeseen high payouts.
- Misrepresenting risk factors on insurance applications is considered fraud and is punishable by law.
- Adverse selection can increase premiums for everyone, affecting industries like health, life, and auto insurance.
Adverse selection occurs in the insurance industry when one party, usually the policyholder, has more information about their risk level than the insurer. This imbalance can lead higher-risk individuals to buy more coverage, raising costs and pushing premiums higher for everyone. It commonly appears in life, health, and auto insurance, where factors like health history, driving behavior, or lifestyle affect risk. Insurers use tools, such as risk assessments, underwriting, and information verification, to better price policies.
How Insurance Premiums Are Calculated
An insurance company provides insurance coverage based on identified risk variables, such as the policyholder’s age, general health condition, occupation, and lifestyle. The policyholder receives coverage within set parameters in return for payment of an insurance premium, a periodic cost based on the insurance company’s risk assessment of the policyholder in terms of the likelihood of a policyholder filing a claim and the probable dollar amount of a claim filed.
Higher premiums are charged to higher-risk individuals. For example, a person who works as a racecar driver is charged substantially higher premiums for life or health insurance coverage than a person who works as an accountant.
Examples of Adverse Selection in Practice
Adverse selection for insurers occurs when an applicant manages to obtain coverage at lower premiums than the insurance company would charge if it were aware of the actual risk regarding the applicant, usually as a result of the applicant withholding relevant information or providing false information that thwarts the effectiveness of the insurance company’s risk evaluation system.
Warning
Knowingly giving false information on an insurance application—which is a crime called insurance fraud—can lead to charges ranging from misdemeanors to felonies at the state and federal levels. Penalties can include tens of thousands of dollars in fines or even imprisonment.
Impact of Adverse Selection on Life and Health Insurance
A prime example of adverse selection in regard to life or health insurance coverage is someone with a nicotine dependency who successfully manages to obtain insurance coverage as a person without a nicotine dependency. Smoking is a key identified risk factor for life insurance or health insurance, so a person who uses nicotine products must pay higher premiums to obtain the same coverage level as someone who doesn’t.
By concealing their substance dependence, an applicant is leading the insurance company to make decisions on coverage or premium costs that are adverse to the insurance company’s management of financial risk.
Adverse Selection’s Effect on Auto Insurance
An example of adverse selection in the provision of auto insurance is a situation in which the applicant obtains insurance coverage based on providing a residence address in an area with a very low crime rate when the applicant actually lives 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 substantially greater than if the vehicle was regularly parked in a low-crime area.
Adverse selection might occur on a smaller scale if an applicant states that the vehicle is parked in a garage every night when it is actually parked on a busy street.
The best car insurance companies will fight adverse selection strategically in order to keep rates competitive.
Insurer Strategies to Prevent Adverse Selection
Since adverse selection exposes insurance companies to high amounts of risk for which they are not receiving appropriate compensation in the form of premiums, it is essential for insurance companies to take all the steps possible to avoid adverse selection situations.
There are three principal actions that insurance companies can take to protect themselves from adverse selection:
- Identify risk factors: The first action is the accurate identification and quantification of risk factors, such as lifestyle choices that increase or lessen an applicant’s risk level.
- Verify applications: The second action is to have a well-functioning system in place to verify information provided by insurance applicants.
- Cap payouts: A third step is to place limits, or ceilings, on coverage, referred to in the industry as aggregate limits of liability, that put a cap on the insurance company’s total financial risk exposure. Insurance companies institute standard practices and systems to implement protection from adverse selection in all three of these areas.
How Is Adverse Selection Different From Moral Hazard?
Adverse selection is when a “bad risk” buys insurance, while moral hazard is the reckless behavior of someone who is insured. Adverse selection happens before purchasing insurance, while moral hazard happens afterward.
How Does Easier Enrollment Affect Adverse Selection?
Some insurance companies worry that easier insurance enrollment will lead to increased adverse selection. However, during the Covid-19 pandemic, the government eased special enrollment rules, leading to an increase in enrollment; a study by the Commonwealth Fund found that despite increased enrollment, there was no increased adverse selection.
How Do Companies Prevent Adverse Selection?
Because adverse selection can affect a company’s bottom line and its ability to pay claims, insurance companies take one or more steps to control it. They may take additional steps to verify applicants, cap payouts, and identify risk. In health insurance, these steps can also include risk adjustment and cost-sharing measures that split cost between the insured and the plan.
The Bottom Line
Adverse selection in insurance occurs when higher-risk policyholders, such as those with greater health, life, or driving risks, are more likely to seek coverage. This creates an imbalance that can increase claims and premiums. To manage this risk, insurers use safeguards outlined in the Key Takeaways, including verifying applicant information, identifying risk factors more carefully, and setting limits on coverage or payouts. These measures help insurers maintain balanced risk pools and keep insurance more affordable for policyholders overall.
