- Adverse selection in insurance is a situation where people living a high-risk lifestyle or one’s in dangerous jobs take life insurance for protecting themselves from the coming risk.
- Another definition of anti selection in health insurance is that when the sellers have information which the buyers do not have, or vice versa, about an aspect of the insurance.
- Life insurance agencies lower their exposure to high-risk claims by increasing premiums or limiting coverage to these categories of people.
Sanjay, a 60 years old, chartered accountant in New Delhi came across a 50,000 Rs. Life insurance plan with Rs. 5,000 monthly premium. With a history of heart issues and diabetes, this offer came as an ideal proposal for him.
On the other hand, when offered the same plan, Ajay, a 32 years old engineer, found it worthless to pay Rs. 5,000 per month since he doesn’t have any pre-existing illnesses.
So, while on one hand, Sanjay took the plan up, Ajay rejected it.
This is the classic case of adverse selection in insurance.
What is adverse selection in insurance?
Adverse selection is a commonly found scenario in the insurance space, either in personal insurance or group insurance space. Here people are having high-risk lifestyles or ones employed in dangerous jobs take up life insurance coverage for protecting themselves against any upcoming risk.
Insurance companies, on the other end, lower their exposure to high-risk claims by lowering the coverage to such class of people. Moreover, insurance companies increase the premium in sync with the risk exposure.
For example, a life insurance company would charge high premiums for adventure sportspeople, or a car insurance provider would charge high from customers in high crime areas. An example of what is adverse selection in health insurance can be seen in how a health insurance provider charges a high premium for people who smoke. As opposed to this, people who don’t follow a high-risk lifestyle are likely to pay less for insurance.
What are the effects of adverse selection in healthcare insurance?
The biggest effect of adverse selection in life insurance or even the health counterpart is that healthy people drop out of the plans under the assumption that they don’t require it, while high-risk individuals remain in the market. This leads to insurance companies paying higher claims compared to the amount of collected premium. The concept of adverse selection in insurance is more or less similar to moral hazard. The latter is where the party, let’s assume the insured, takes up insurance while providing details about their health condition with the intent to not pay extra premiums.
In both cases, there is a massive information asymmetry between the insurer and the insured. However, the difference in adverse selection and moral hazard lies in when it occurs. It is assumed that in case of moral hazard, asymmetrical information was there when the agreement has been made, while in case of adverse selection, there is a lack of asymmetrical information till the time the contract was agreed on.
How do health insurers attempt to control adverse selection in insurance?
The adverse selection solutions are usually two-fold. The first is solving the problem of asymmetrical information. There should be intermediaries between insurance providers and investors explaining the blacks and whites of the contract to the insured while highlighting the stage of the insured to the insurer for complete transparency.
The other side of the solution would be to group high-risk individuals, separating them from low-risk individuals. This way, the insurance companies would be able to charge different premium amounts for individual risk types.
Adverse selection in insurance continues to be a pestering issue. Although insurance providers are making efforts to fill the asymmetrical information gap, there is a lot of left to be filled. This article was our contribution to explaining to you what the popular term of the group health insurance space stands for.
Hope it helped!