Adverse selection and insurance

Insurance is a co-operative form of distributing a certain risk over and group of persons exposed to it. All individual generally do not have equal level of risk of loss. Some of them may have been facing higher than average chance of loss. The insurer should deal with the probability of loss exposed to the applicants, while accepting and determining the premium.

If a person is exposed greater than average risk, he will be more easy to insure to cover the higher risk. The insurer must find out the level of risks exposed to him before accepting and determining the insurance. When insurance proposal is accepted from the persons highly exposed to the risks, the insurer must determine higher premium than average. Otherwise, adverse selection arises. Hence, adverse selection is the tendency of persons with a higher than average chance of loss to seek insurance at standard levels. The insurers must deal with the problem of adverse selection while accepting the insurance proposal. For example, adverse selection arises when,

1.        A person with serious health problem seeks life or health insurance at standard rates.

2.        A careless driver with weak eyesight seeks auto insurance at standard rates.

3.        A business firm that has been repeatedly robbed or burglarized and that seeks crime insurance at standard rates of premium.

It has been cleared from above examples that some of the groups facing the same risks have greater chance of loss. If such applicants with a higher than average chance of loss succeed in obtaining the coverage at standards rates, we say that the insurer is adversely selected against. The insurer should not underwrite such application for insurance in standard rate of premium. Otherwise, the insurer may be facing more risk than average and more likely to pay the insured amount. This may lead to increment in premium, which may be injustice to other insured with average chance of loss.

 The risk is not exposed in an equal level to all individuals. The degree or level of risk may vary slightly from person to person. So, adverse selection can never be completely eliminated. However, it can be controlled by careful underwriting. Underwriting standards are not met, the insurance is denied. The insurer demands extra premium from the applicants, who are unable to meet the underwriting standards. The insurers frequently sell insurance to applicants who have a higher-than-average chance of loss, but such claimant must pay higher premiums.

The problem of adverse selection arises when applicants with a higher than average chance of loss succeed in obtaining the coverage at standard or average rates. Policy for example:

1. Higher premium clause for life insurance to mineworkers.

2. Higher premium clause for health insurance to workers of chemical factories.

3.The pre-existing conditions clause in health insurance.

4. The suicide clause in life insurance.