How Adverse Selection Is Used to Determine Insurance Coverage

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Adverse selection refers to a buyer having more information than the seller. In the case of insurance, this refers to insurance companies being unaware of a potential loss risk because it has not been disclosed by the person buying an insurance policy. Insurance companies must make a profit to stay in business and adverse selection hinders this process. Why is this important to the insurance consumer? Because of adverse selection, an insurance company may have to increase its rates, making it more difficult to obtain insurance coverage.

Examples of Adverse Selection in Insurance

Examples of adverse selection in life insurance include situations where someone with a high-risk job, such as a race car driver or someone who works with explosives, obtain a life insurance policy without the insurance company knowing that they have a dangerous occupation. Another life insurance example of adverse selection would be a smoker who either does not disclose the fact that he smokes on his life insurance application or lies and says he is not a smoker. A smoker pays more for life insurance because of the increased risk of death. In both examples, had the insurance company known about the increased risk of loss, it would have properly classified the risk and charged an appropriate insurance premium based on the greater probability of a loss.

With auto insurance, an example of adverse selection would be if a person who lives in a high crime area does not disclose this information or lies on his insurance application about his address. Another example of adverse selection in auto insurance is a person who is untruthful about his driving record and has existing tickets and/or accidents on his driving record. Because of the omission of information to the insurance company, the insured receives a lower insurance premium on his auto insurance.

The National Flood Insurance Program (NFIP) was created because of adverse selection. Homeowners and renters that lived in flood zones did not always disclose this information to the insurance company. Meanwhile, those homeowners who were at very little risk of flooding, stayed away from buying flood insurance altogether. This created an unstable flood insurance market and the government had to take over flood insurance, which is available only in certain areas.

Impact on Insurance Rates

Ideally, an insurance company knows the appropriate rate to charge for insurance based on the known risk factors. However, when people are not truthful or withhold information from their insurance company, the insurance company charges less for the premium because it does not know about the risk. Because of adverse selection, insurance companies may have to increase insurance rates for coverage because of these “unknown factors” when writing an insurance policy.

What Insurance Companies Do to Combat Adverse Selection

To combat adverse selection, insurance companies need ways to identify groups that are at greater risk of loss. One way of doing this is the insurance questionnaire. You may have wondered why the insurance company asks you so many questions before you buy an insurance policy. Here is why the insurance company asks you so many questions—it is trying to properly classify the risk and determine the appropriate insurance rate for the exposure to loss. The insurance company uses the information you provide on your insurance application to help underwrite the policy.

If an insurance company does determine that you intentionally gave false or inaccurate information on your insurance application, it can cancel your policy or increase your insurance premium. In medical insurance, applicants may be asked to undergo a physical examination so that the insurance company can identify “high-risk” individuals and charge the appropriate insurance premium.

Why It Matters to the Insurance Consumer

Because of adverse selection, insurance companies are sometimes forced to increase insurance rates to cover these “unknown risks.” It is important to be truthful in any questions asked of you by the insurance company when purchasing a policy. The insurance company uses this information to accurately classify risk and assign the proper policy coverage and premium. If you are not truthful in your disclosures to the insurance company, this is called misrepresentation and could lead to your policy being cancelled or an increase in your insurance premium. Dishonestly on an insurance application can also mean that the insurance company does not have to pay your claim because of the “utmost good faith” doctrine which says that the insurance applicant must answer all questions truthfully and completely.