Adverse Selection  

Definition of adverse selection: Adverse selection occurs when a product or service is selected by only a certain group of people who offer the worst return for the company. Adverse selection occurs because of information asymetries and difficulties in selecting customers.

Adverse Selection in Health Insurance

Suppose an insurance firm offered health insurance to the general public. It is likely to have the highest take up rate amongst unhealthy people. People who don't exercise, people who smoke. They are the group most likely to need health care, therefore, it makes sense for them to take out insurance. Healthy people don't see the point, if the price of health insurance is determined by the average unhealthy person.

If insurance premiums are based on the needs of smokers, then the premiums will be high. Therefore, there is no incentive for healthy people to take out the insurance.

Solutions to Adverse Selection

To avoid adverse selection, firms need to try and identify different groups of people. This is why health insurance premiums are higher for smokers and obese people.

 

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