In a minimum of 250 words, describe the concept known as adverse selection? Expl

Question

In a minimum of 250 words, describe the concept known as adverse selection? Explain how does its existence affect the market for health insurance? List and describe a few examples of insurance companies protect themselves from adverse selection? For the second half of Week Five (5) discussion, explain moral hazard and how does it affect the demand for health insurance? What approaches do insurance companies use to control its existence? Once your material is posted, be sure to review and comment on the materials that at least two of your peers have located. Once your material is posted, be sure to review and comment on at least two of your peers postings. Your initial post to the given topic of discussion should contain a minimum of 2–3 peer-reviewed references.

Explanation / Answer

Adverse selection refers generally to a situation where sellers have information that buyers do not have, or vice versa, about some aspect of product quality. In the case of insurance, adverse selection is the tendency of those in dangerous jobs or high-risk lifestyles to get life insurance. To fight adverse selection, insurance companies reduce exposure to large claims by limiting coverage or raising premiums.
Adverse selection occurs when one party in a negotiation has relevant information the other party lacks. The asymmetry of information often leads to making bad decisions, such as doing more business with less-profitable or riskier market segments.

Adverse Selection in the Marketplace -A seller may have better information than a buyer about products and services being offered, putting the buyer at a disadvantage in the transaction. For example, a company’s managers may more willingly issue shares when they know the share price is overvalued compared to the real value; buyers can end up buying overvalued shares and lose money. In the secondhand car market, a seller may know about a vehicle’s defect and charge the buyer more without disclosing the issue.

Adverse Selection in Insurance

Because of adverse selection, insurers find that high-risk people are more willing to take out and pay greater premiums for policies. If the company charges an average price but only high-risk consumers buy, the company takes a financial loss by paying out more benefits or claims. However, by increasing premiums for high-risk policyholders, the company has more money with which to pay those benefits. For example, a life insurance company charges higher premiums for race car drivers. A car insurance company charges more for customers living in high crime areas. A health insurance company charges higher premiums for customers who smoke. In contrast, customers who do not engage in risky behaviors are less likely to pay for insurance due to increasing policy costs.

The Basics of Insurance Coverage and Premiums

An insurance company provides insurance coverage based on identified risk variables, such as the policyholder's age, general health condition, occupation and lifestyle. The policyholder receives coverage within set parameters in return for payment of an insurance premium, a periodic cost based on the insurance company's risk assessment of the policyholder in terms of the likelihood of the policyholder filing a claim and the probable dollar amount of a claim filed. Higher premiums are charged to higher-risk individuals. For example, a person who works as a racecar driver is charged substantially higher premiums for life or health insurance coverage than a person who works as an accountant.

Examples of Adverse Selection

Adverse selection for insurers occurs when an applicant manages to obtain coverage at lower premiums than the insurance company would charge if it were aware of the actual risk regarding the applicant, usually as a result of the applicant withholding relevant information or providing false information that thwarts the effectiveness of the insurance company's risk evaluation system. Potential penalties for knowingly giving false information on an insurance application range from misdemeanors to felonies on state and federal levels, but the practice occurs nonetheless.

A prime example of adverse selection in regard to life or health insurance coverage is a smoker who successfully manages to obtain insurance coverage as a nonsmoker. Smoking is a key identified risk factor for life insurance or health insurance, so a smoker must pay higher premiums to obtain the same coverage level as a nonsmoker. By concealing his behavioral choice to smoke, an applicant is leading the insurance company to make decisions on coverage or premium costs that are adverse to the insurance company's management of financial risk.

An example of adverse selection in the provision of auto insurance is a situation in which the applicant obtains insurance coverage based on providing a residence address in an area with a very low crime rate when the applicant actually lives in an area with a very high crime rate. Obviously, the risk of the applicant's vehicle being stolen, vandalized or otherwise damaged when regularly parked in a high-crime area is substantially greater than if the vehicle was regularly parked in a low-crime area. Adverse selection might occur on a smaller scale if an applicant states that the vehicle is parked in a garage every night when it is actually parked on a busy street.

How Insurance Companies Protect Themselves Against Adverse Selection

Since adverse selection exposes insurance companies to high amounts of risk for which they are not receiving appropriate compensation in the form of premiums, it is essential for insurance companies to take all the steps possible to avoid adverse selection situations. There are three principal actions that insurance companies can take to protect themselves from adverse selection. The first is accurate identification and quantification of risk factors, such as lifestyle choices that increase or lessen an applicant's risk level. The second is to have a well-functioning system in place to verify information provided by insurance applicants. A third step is to place limits, or ceilings, on coverage, referred to in the industry as aggregate limits of liability, that put a cap on the insurance company's total financial risk exposure. Insurance companies institute standard practices and systems to implement protection from adverse selection in all three of these areas.

Solutions to Adverse Selection

In the case of insurance, avoiding adverse selection requires identifying groups of people more at risk than the general population and charging them more money. For example, life insurance companies go through underwriting when evaluating whether to give an applicant a policy and what premium to charge. Underwriters typically evaluate an applicant’s height, weight, current health, medical history, family history, occupation, hobbies, driving record, and lifestyle risks such as smoking; all these issues impact an applicant’s health and the company’s potential for paying a claim. The insurance company then determines whether to give the applicant a policy and what premium to charge for taking on that risk.

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