Adverse selection is a significant risk for insurance companies. It occurs when high-risk applicants are able to obtain insurance coverage at rates that do not match their level of risk. This results in the insurance company taking on more risk than they anticipated. Fortunately, insurance companies have strategies to protect themselves from adverse selection.
What is Adverse Selection?
Adverse selection refers to a situation where an insurance applicant has more knowledge about their risk profile than the insurer. The applicant uses this asymmetric information to obtain coverage at a lower premium than their risk level warrants.
For example, say a smoker applies for life insurance and does not disclose their smoking habit. Since smoking increases health and mortality risks, the insurer charges a lower premium based on the assumption the applicant is a non-smoker. The insurer takes on more risk than they realized by offering coverage at that premium level.
Adverse selection is a threat to insurers because it can lead to:
- Higher than expected claim payouts
- Loss of profits
- Instability in the insurance pool
- Higher premiums for all policyholders to offset losses
Left unchecked, adverse selection creates a death spiral where rates climb higher and higher, eventually making insurance unaffordable or even unavailable.
How Insurance Companies Identify and Prevent Adverse Selection
Insurance companies utilize various strategies to identify high-risk applicants and prevent adverse selection. Common approaches include:
Careful underwriting is the first line of defense. Insurers collect extensive information on applicants to accurately gauge risks. Data gathered can include:
- Medical history
- Lifestyle habits
- Driving record
- Credit score
- Hobbies and activities
Insurers may also require medical exams, lab tests, or attendance at specialized clinics.
Insurers take steps to verify the information provided by applicants is truthful and accurate. This can involve:
- Calling doctors to confirm health history
- Requesting motor vehicle records
- Performing credit checks
- Conducting in-home inspections for property insurance
- Interviewing the applicant’s friends, family, and coworkers
Catching intentional misrepresentations or omissions during underwriting allows the insurer to deny coverage or re-rate the policy appropriately.
Insurers will exclude coverage for specific conditions or situations that pose an unacceptable level of risk. Common exclusions include:
- Pre-existing medical conditions
- Certain dangerous hobbies or occupations
- Damage from floods or earthquakes
- Drivers under 25 years old
Exclusions shift the highest risks back to the insured.
Insurers limit the amount of risk they take on with any single policyholder by capping coverage. Common caps used to control exposure are:
- Dollar limits on claim payouts
- Restricted durations of benefit payments
- Limited scopes of covered services
- Maximum refunds or reimbursements
Caps ensure claim costs cannot spiral out of control for any single policy.
Deductibles and Copays
Deductibles require the policyholder to pay some of their own costs before insurance coverage kicks in. Copays involve flat fees per service. Both deductibles and copays incentivize policyholders not to over-utilize benefits. This protects against adverse selection by individuals attempting to exploit the insurance policy.
Group insurance plans like employer-sponsored health insurance avoid adverse selection by pooling both high and low-risk members together. The larger, more diverse insurance pool balances out risks and stabilizes rates.
Why Do Insurance Companies Need To Manage Adverse Selection?
If left unchecked, adverse selection produces significant financial consequences for insurers including:
Higher claims costs – When underpriced high-risk policyholders file frequent or expensive claims, loss payouts escalate.
Thinner profit margins – Escalating claims eat into profits as premium revenue fails to keep pace with higher costs.
Instability in the insurance pool – As premiums climb to offset losses, low-risk members drop coverage. This further concentrates high-risk policyholders in the pool.
Risk of insolvency – If adverse selection is severe enough, the insurer can collapse under the weight of runaway claims costs.
Managing adverse selection is crucial for insurance companies to maintain a sustainable business model.
How Adverse Selection Affects Consumers
Adverse selection also produces negative impacts for consumers including:
Reduced availability of insurance – As insurers struggle to control adverse selection, some exit insurance markets completely while others selectively curtail high-risk coverage.
Higher premiums – Even insured consumers wind up paying higher premiums as insurers raise rates across the board to counteract losses from high-risk policyholders.
Declined coverage – With tightened underwriting, consumers with even moderate health conditions or risk factors can be denied coverage.
Controlling adverse selection enables insurers to keep premiums affordable and continue serving a wide range of consumers.
Common Examples of Adverse Selection
Adverse selection can arise in any type of insurance but is most prevalent in health and life insurance. Some classic examples include:
A person with a chronic illness purchases extensive coverage knowing they will need frequent medical care.
An individual planning a elective surgery signs up for a policy that will pay for the procedure.
A woman gets pregnant and immediately obtains maternity coverage.
A chain smoker buys a large life insurance policy without disclosing their tobacco use.
A person with a terminal disease purchases life insurance to create an inheritance for their heirs.
An elderly applicant downplays their declining health to qualify for coverage.
A motorist with past drunk driving convictions gets insurance without declaring their driving record.
An inexperienced young driver secures the same coverage as experienced drivers.
A policyholder increases their limits right before filing a major claim.
A homeowner buys expansive coverage right before making a large hail damage claim.
A dwelling with prior fire damage obtains new insurance without disclosing the past loss history.
An individual with a degenerative condition purchases disability insurance without revealing their diagnosis.
An applicant about to undergo a risky elective surgery takes out a disability policy beforehand.
How Government Regulations Can Worsen Adverse Selection
Government regulations aimed at expanding access to insurance can sometimes worsen adverse selection issues for insurers. Examples include:
Guaranteed issue – This requirement forces insurers to offer coverage to all applicants regardless of risk factors. High-risk consumers cannot be declined.
Community rating – Insurers cannot price policies according to individual risk levels. Higher risk consumers pay the same rates as lower risks.
Mandated benefits – Certain types of services must be covered which attracts consumers seeking those specific benefits.
While regulations try to make insurance more available, they can exacerbate adverse selection by removing insurers’ tools for managing high-risk applicants.
Solutions Insurers Use To Combat Adverse Selection
Even with potential regulatory constraints, insurers utilize strategies to counteract adverse selection:
Advanced data analytics identify coverage-seeking behavior predictive of higher risk.
Incentives for low-risk consumers even out the risk pool. Discounts, rewards programs, and customized policies encourage healthier individuals to buy insurance.
Market reforms that emphasize personal responsibility over guaranteed issue alone. This includes allowing premium variances based on lifestyle choices.
Plan design features like high deductibles or narrow provider networks help control claims costs despite taking on higher risk applicants.
Vigilance around adverse selection enables insurers to open doors to broader consumer access without jeopardizing stability.
How Can Consumers Avoid Adverse Selection?
On the consumer side, honesty remains the best policy when applying for insurance. Attempting to game the system may provide short term savings but ultimately works against consumers’ interests through higher industry-wide premiums. Ways consumers should avoid adverse selection include:
Making full disclosures during underwriting about past medical issues, conditions, or claims.
Reporting any major life changes that occur after a policy is issued which alter risk factors.
Not waiting until a major expense arises to suddenly obtain or increase insurance coverage.
Dropping unneeded coverage when personal risk factors improve rather than maintaining existing higher limits.
Working cooperatively with insurers facilitates the most favorable premiums and journey through the claims process.
The Importance of Managing Adverse Selection
Left unchecked, adverse selection produces a downward spiral of financial instability for insurers and increasingly unaffordable or restricted coverage for consumers.
Insurers must vigilantly identify and deny coverage to unacceptably high-risks outside the normal range. But with proper adverse selection controls in place, expanded access and more affordable premiums are achievable for the majority of insurance applicants.
Keeping coverage available and protection intact for consumers tomorrow means insurers must judiciously manage risks today. Ongoing focus on adverse selection is key to bringing
When Insurance Companies Act in Bad Faith, What are your options?
How do insurance companies protect themselves?
How do insurance companies protect themselves against losses due to adverse selection and moral hazard?
What are some methods the insurance industry uses to avoid the adverse selection problem?
What is one way insurers can avoid adverse selection problems?