Adverse Selection

A situation wherein an individual’s demand for insurance (the propensity to buy insurance and/or the quantity purchased) is positively correlated with the individual’s risk of loss (e.g., higher risks buy more insurance), and the insurer is unable to allow for this correlation in the price of insurance. This may be because of private information known only to the individual or because of regulations or social norms which prevent the insurer from using certain categories of known information to set prices (e.g., the insurer may be prohibited from using such information as gender, ethnic origin, genetic test results, or preexisting medical conditions).

The potentially adverse nature of this phenomenon can be illustrated by the link between smoking status and mortality. Non-smokers, on average, are more likely to live longer, while smokers, on average, are more likely to die younger. If insurers do not vary prices for life insurance according to smoking status, life insurance will be a better buy for smokers than for non-smokers. So smokers may be more likely to buy insurance, or may tend to buy larger amounts, than non-smokers, thereby raising the average mortality of the combined policyholder group above that of the general population.