Adverse Selection

Understanding How Adverse Selection Influences Insurance and Other Exposures

Adverse Selection
Adverse selection is a term, originally from the insurance industry, that describes a situation in which the person likely to sign up for a service is one who is likely to cost more to the person or institution providing the service. It has important implications for everything from healthcare to capital raising in public securities markets. David Malan / Photographer's Choice / Getty Images

You might have heard about a financial, economic, or statistical concept known as adverse selection, especially in the context of health insurance, life insurance, or some other probability exposure.  What is adverse selection?  Why should you care?  Those are great questions.

Adverse selection is a term used primarily in insurance although it is useful for other industries, as well. It refers to a situation in which the buyer or seller of a product knows something about the product quality or condition that the other party does not know, allowing them to have a better estimate of what the true cost of the product should be.

 This insight into the true cost, or value, creates information asymmetry.  In certain situations, this can be economically devastating to the person providing or sourcing the product as they find themselves on the hook for much more than they ever anticipated.

Let's examine life insurance and health insurance policies for a moment.  In this context, adverse selection means that insurance is going to be more expensive than it should be for those who are healthy and responsible, and less expensive than it should be for those who are unhealthy and likely to need medical attention. This happens because the insurance company cannot possibly know the individual factors that determine every single person's health file, so insurance rates are overpriced to good risk and underpriced to bad risk. If not managed properly, adverse selection can result in a "book' of insurance business of extremely bad policies that will cost the company substantial sums of money and, in some cases, drive it out of business.

Real-World Examples of Adverse Selection

It might help to discuss some specific, real-world examples of adverse selection.  

  • Workers in high-risk occupations, or with certain dangers they, and not the insurance company, know about, are more likely to seek out life insurance.  The desire to protect their loved ones in light of what they acknowledge is a real probability of death means the typical person applying for life insurance has higher risk than the population as a whole, creating adverse selection.  On some level, you already know this.  You don't see many perfectly healthy, in-shape, disciplined, single, childless adults running out to sign up for life insurance the first chance they get.
  • Initial public offerings, secondary offerings, and other capital raising activities are often subject to adverse selection.  If a founder creates a business, grows it, then decides it's time to sell part of his or her holdings to you, they are in a much better place to determine whether or not they, or you, are getting the best deal.  This is the reason some legendary value investors, such as Benjamin Graham, were not keen on participating in IPOs, which gave a structural advantage to the seller.  Other times, new investors will require a discount in the form of what academics call an "equity risk premium" to offset the adverse selection risk.  (To learn more, read Should You Invest in an IPO?)
  • Adverse selection in health insurance is caused when healthy people buy managed care or low-premium, low-coverage products and unhealthy people (or those prone to certain health risks that run along family lines) opt for more generous plans.  The health insurance company cannot possibly know everything about the patient to the degree the patient himself or herself does, meaning the patient is in a better position when it comes to knowing how attractive a given premium quote is.

There was, and remains, some major concern that the Affordable Care Act could result in adverse selection because if the state exchanges are not setup intelligently, it could result in large numbers of those in poor health enrolling through the exchanges, driving up prices and taxpayer cost as a result of the promised subsidies, while those in good health opt to remain in off-exchange, private health insurance plans.

 Experts have identified multiple solutions, such as requiring uniformity in products offered both on and off exchanges as part of regulatory changes and consolidating the individual and small business policy pools over time, but the real-world consequences will take years to make themselves fully known.