Written by Q: What is adverse selection?
AIS Answer: Adverse selection is a term in the insurance industry that essentially means those who are poor risk’s need insurance more than those who are better risks.
Insurance companies try at all costs to limit their exposure and ultimately losses to adverse selection, or more importantly higher risk individuals (those who are more likely to file a claim) that need insurance.
While the term adverse selection is easy to define, the process of coming up with a metric that determines who is and who isn’t labeled under adverse selection a bit trickier.
Adverse selection is just one of many ways insurance companies try to increase profit, and it makes sense to take on lower risk policyholders that may never need to file a claim. Though not 100% accurate, the insurance industry is all about the past as an indicator for the future and this is one metric that helps underwriting calculate their own risk.
is that even legal? How can an insurance company selectively choose which people they want to insure based on whether they supposedly “need it” or not. How can they judge that?
it’s no different than location based (zip code) statistics. Insurance companies have a ton of ways to come up with reasons to charge more or less for certain people.