Adverse Selection and Insurance

Abstract

If insurance providers cannot determine the risk levels of their various clients, but individuals do know this information, then adverse selection arises. We present the canonical models of adverse selection in insurance markets that shed some light on the economic consequences of this phenomenon. Under symmetric information, companies observe all relevant risk characteristics. By charging risk‐type specific prices, all risk types purchase full coverage. The result is an efficient allocation of resources with no risk bearing costs incurred by individuals. Under asymmetric information (adverse selection), if contracting is exclusive (i.e. each insured can contract with one and only one insurer), high risks end up with full insurance, but low‐risk types end up with partial coverage. Under nonexclusive contracting (i.e. each insured may purchase contracts from more than one insurance provider), higher risk individuals end up with too much insurance, while low risk individuals end up with too little. In either case, the allocation of resources is inefficient.

Key Concepts

  • Under symmetric information, each risk type purchases full insurance at the risk type specific actuarially fair odds rate and this allocation is pareto efficient. However, if these contracts were offered under asymmetric information, one expects high risk types to report being low risk in order to receive a more favorable contract
  • If insurance companies do not have access to information about immutable characteristics of their potential customers where these characteristics affect the risk level of some activity, then this creates a situation of asymmetric information and a problem of adverse selection (also called antiselection).
  • As individuals who are ‘bad risks’ (i.e. low risk) will desire more insurance than ‘good risks’ (i.e. high risk) if the price is the same for all, then insurers would end up selling more insurance to the bad risks and so the overall price of insurance would reflect this.
  • If a pooling contract is offered and purchased, there is always a profitable deviation that is only attractive to low risk types but not high risk types. However, if insurance companies have sufficient foresight, they would not offer such a contract in the first place as such a deviation will make losses once other firms react to it.
  • Adverse selection may also result in screening strategies whereby insurers offer higher coverage at a higher unit price in order to attract high‐risk types with lower risk types ending up with less insurance coverage.

Keywords: insurance; adverse selection; linear pricing; nonlinear pricing; asymmetric information

Figure 1. Equilibrium with a single risk type.
Figure 2. Equilibrium with two risk types under symmetric information.
Figure 3. Consumer demand under asymmetric information with linear pricing.
Figure 4. Impossibility of a pooling equilibrium under exclusive contracting.
Figure 5. Illustration of separating contracts being a Nash equilibrium.
Figure 6. Illustration of Wilson foresight (E2) pooling equilibrium.
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Further Reading

Crocker KJ and Snow A (1986) The efficiency effects of categorical discrimination in the insurance industry. The Journal of Political Economy 94: 321–344.

Doherty NA and Thistle P (1996) Adverse selection with endogenous information in insurance markets. Journal of Public Economics 632: 83–102.

Durnin M, Hoy M and Ruse M (2012) Genetic testing and insurance: the complexity of adverse selection. Ethical Perspectives 19 (1): 123–154.

Hoy M (1982) Categorizing risk in the insurance industry. Quarterly Journal of Economics 97 (2): 321–336.

Hoy M (2006) Risk classification and social welfare. Geneva Papers on Risk and Insurance: Issues and Practice 31: 245–269.

Hoy Michael (2014) Insurance and Human Genetics: Insurance Market Perspective. In: eLS. Chichester: John Wiley & Sons, Ltd. DOI: 10.1002/9780470015902.a0005206.pub2.

Lemmens Trudo and Bombard Yvpmme (2017) Insurance and Human Genetics: Approaches to Regulation. In: eLS. Chichester: John Wiley & Sons, Ltd. DOI: 10.1002/9780470015902.a0005204.pub3.

Polborn M, Hoy M and Sadanand A (2006) Advantageous effects of regulatory adverse selection in the life insurance market. Economic Journal 116: 327–354.

Rothschild C (2011) The efficiency of categorical discrimination in insurance markets. Journal of Risk and Insurance 78 (2): 267–285.

Rothschild C (2015) Nonexclusivity, linear pricing, and annuity market screening. The Journal of Risk and Insurance 82 (1): 1–32.

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Hoy, Michael, and Lun, Esmond (Tin Ching)(Jul 2017) Adverse Selection and Insurance. In: eLS. John Wiley & Sons Ltd, Chichester. http://www.els.net [doi: 10.1002/9780470015902.a0026687]