Adverse Selection

Originally coined by the insurance industry to explain the cause of upwardly spiraling pricing resulting from worsening loss histories proportional to the deteriorating risk characteristics of those insured; this term has been adopted by the practitioners of economics, statistics and risk management. The most basic definition of adverse selection is that the insurance company is chosen against by those most likely to suffer loss.

Adverse selection begins with rates that do not allow recognition of an individual's or entity's specific risk characteristics. When pricing coverage, everyone is treated the same (no rate differences). Premiums are relatively high, and those most likely to suffer loss purchase insurance, but those not likely or less likely to suffer injury or damage choose not to purchase protection from that carrier. The insurance carrier does not have an adequate spread of risk (premium spread among no-or-low-loss risks and high frequency or high severity insureds) to cover expenses and pay losses and must raise rates. Some insureds cannot afford the new rates and drop coverage, again lessening the pool of insureds among whom expenses and losses can be spread. Likely, the only insureds remaining are those almost guaranteed to suffer a loss; the carrier has to increase rates - again; more drop out, and so on and on this cycle continues (higher rates, fewer insureds). Academically referred to as the "adverse selection death spiral," this process continues until the company becomes insolvent or is subsidized by the government.

The National Flood Insurance Program (NFIP) is an example of a market historically subject to adverse selection. Only government subsidies keep it free of the aforementioned death spiral.

Applying actuarial sound rates coupled with premium credits and debits based on individual risk characteristics allows carriers to avoid adverse selection - and the death spiral. Better-than-average risks garner preferred rates (encouraging loyalty, and providing a funding source subsidizing average and below average risks); average risks pay the actuarially developed average rate (a fair premium for the exposure presented); and lower-than-average risks are charged higher rates or are declined outright. Insurance carriers enjoy an adequate spread of risk and avoid adverse selection.

Comments (4)

Feature Products

Auto Dealers

Marine Artisan Program

Information Security and Privacy Coverage

Cargo - Auto Physical Damage Combined