Definition
Adverse Selection
Adverse selection is the tendency for higher-risk individuals to seek insurance more eagerly than lower-risk ones, skewing the risk pool.
Because people know more about their own health and habits than the insurer does, those most likely to claim, such as the seriously ill seeking health cover, are keenest to buy. If unchecked, this pushes up claims and premiums, driving away healthier buyers in a 'spiral'.
Insurers combat adverse selection through underwriting, medical tests, waiting periods, pre-existing disease clauses and pricing by risk class. Mandatory or group schemes also dilute the effect by pooling good and bad risks together. Managing adverse selection is essential to keeping voluntary insurance sustainable.
Related terms
- UnderwritingUnderwriting is the process by which an insurer evaluates a risk, decides whether to accept it, and on what terms and premium.
- Moral HazardMoral hazard is the increased risk that arises when being insured changes a person's behaviour, making them less careful or more prone to claim.
- Pooling of RiskPooling of risk is the core insurance mechanism whereby premiums from many insured parties are pooled to pay the losses of the unfortunate few.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.