Adverse Selection
A situation where individuals with higher risk are more likely to purchase insurance than those with lower risk, leading to an unbalanced risk pool. This occurs because high-risk individuals know they're more likely to need coverage and are therefore more motivated to buy insurance than low-risk individuals.
Example
“The insurance company experienced adverse selection when healthy young adults opted out of their health plan, leaving mostly older, sicker individuals in the risk pool and driving up costs for everyone.”
Memory Tip
Think 'Bad Selection' - it's when mostly the 'bad risks' select to buy insurance, leaving out the 'good risks' who help balance costs.
Why It Matters
Adverse selection can cause insurance premiums to spiral upward as low-risk individuals drop coverage due to high costs, leaving increasingly expensive high-risk individuals in the pool. Understanding this concept helps explain why some insurance is mandatory and why insurers use detailed underwriting processes.
Common Misconception
People often think insurance companies can simply raise prices to handle adverse selection, but this usually makes the problem worse by driving away even more low-risk customers, creating a 'death spiral' where only the highest-risk individuals remain.
In Practice
A voluntary life insurance plan at a company initially attracts 1,000 employees paying $50 monthly. However, mostly older employees and those with health issues sign up, while healthy younger workers skip it. Claims run 150% higher than expected, forcing premiums to $75 monthly. This causes 300 healthy employees to drop coverage, leaving 700 higher-risk individuals. Claims per person increase further, pushing premiums to $100 monthly, causing another 200 to leave. Eventually, only 500 very high-risk employees remain paying $130 monthly each, making the insurance unaffordable for everyone else and demonstrating how adverse selection can destroy an insurance pool.
Etymology
The term combines 'adverse' meaning harmful or unfavorable, with 'selection' referring to the process of choosing insurance. The concept was first formally described by economists in the 1970s, though insurance companies had observed this phenomenon for decades.
Common Misspellings
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