What is The Adverse Selection Problem?

# What is The Adverse Selection Problem?

To understand how adverse selection can strangle an insurance market, recall the situation of 100 drivers who are buying automobile insurance, where 60 drivers had very low damages of \$100 each, 30 drivers had medium-sized accidents that cost \$1,000 each, and 10 of the drivers had large accidents that cost \$15,000. That would equal \$186,000 in total payouts by the insurance company. Imagine that, while the insurance company knows the overall size of the losses, it cannot identify the high-risk, medium-risk, and low-risk drivers. However, the drivers themselves know their risk groups. Since there is asymmetric information between the insurance company and the drivers, the insurance company would likely set the price of insurance at \$1,860 per year, to cover the average loss (not including the cost of overhead and profit). The result is that those with low risks of only \$100 will likely decide not to buy insurance; after all, it makes no sense for them to pay \$1,860 per year when they are likely only to experience losses of \$100. Those with medium risks of a \$1,000 accident will not buy insurance either. Therefore, the insurance company ends up only selling insurance for \$1,860 to high-risk drivers who will average \$15,000 in claims apiece, and as a consequence, the insurance company ends up losing considerable money. If the insurance company tries to raise its premiums to cover the losses of those with high risks, then those with low or medium risks will be even more discouraged from buying insurance.

Rather than face such a situation of adverse selection, the insurance company may decide not to sell insurance in this market at all. If an insurance market is to exist, then one of two things must happen. First, the insurance company might find some way of separating insurance buyers into risk groups with some degree of accuracy and charging them accordingly, which in practice often means that the insurance company tries not to sell insurance to those who may pose high risks. Another scenario is that those with low risks must buy insurance, even if they have to pay more than the actuarially fair amount for their risk group. The notion that people can be required to purchase insurance raises the issue of government laws and regulations that influence the insurance industry.

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