Adverse Selection in Insurance
► This case occurs when the insurer conceals a vital parameter in the insurance, that puts the insurer at loss. Thus, the insurance premium is lesser, since the insurer has not factored the risk while calculating the risk potential, due to asymmetric information. As such, the insurance will be less profitable for the insurer, since he is not aware of a critical information that might increase the chances of the insured event happening.
► How adverse selection affects the health insurance market: This sector is most prone to adverse selection. Typically, those who are at a higher risk to health hazards will find it beneficial to buy an insurance coverage, than a healthy person who is at much lower risk. Those who are healthy will find the premiums too high to pay, hence, they will avoid taking an insurance cover. Also, the insured might hide vital data that might threaten his health or life, and choose not to disclose the information to the insurer. For example, a smoker is at more risk to health hazards, and hence, he will tend to buy an insurance policy to mitigate the risk, than a non-smoker. That means, even non-smokers have to pay high premium, hence, that dissuades them from buying the insurance policy. This is a huge loss to the insurance company. Sometimes, the insurance company might not be able to distinguish between high-risk and low-risk investors, due to which, it might be difficult for them to compute the insurance premium.
► To curb such a situation, the insurance company might make different plans, and accordingly, the potential insurance investors will choose from the plans. Of course, those who wish for a higher recovery amount will go for a plan, even if it has a high premium, and those with lesser requirements will go for a plan that has lesser insurance premium, though it implies lesser insurance coverage.
► The other alternative for the insurance company can be to incur costs in making a background check and collecting information about potential insurance investors, thereby making it easy to factor the risk areas, if any.