Question

How might adverse selection make it difficult for an insurance market to operate?

Short answer

Adverse selection in insurance markets occurs when individuals with higher risks are more likely to purchase insurance, creating an imbalance between high-risk and low-risk policyholders. This can lead to higher premiums and further adverse selection, as low-risk individuals may decide to forgo insurance due to high costs. In extreme cases, an insurance market can collapse due to a lack of low-risk policyholders. To address this issue, insurance companies may require more detailed information about risk factors, differentiate premiums based on risk levels, or rely on government regulations or subsidies to promote transparency and incentivize low-risk individuals to purchase insurance.

Step-by-step solution

Understand Adverse Selection in Insurance Markets

Adverse selection is a term used in economics and insurance to describe a scenario where one party possesses more relevant information about the risk involved than the other party. This can lead to adverse consequences, as the party with better information may take advantage of the situation by securing better terms or conditions for themselves. In insurance markets, adverse selection often occurs when people with higher risks of claims are more likely to purchase insurance, while those with lower risks may choose to self-insure or not purchase insurance at all.

Identify the problem created by Adverse Selection

The main problem of adverse selection in insurance markets is the imbalance it creates between high-risk and low-risk individuals. If insurers do not have enough information about the risks associated with each individual, they may not be able to adequately price their policies. As a result, insurers may charge higher premiums to avoid losses, and this can lead to further adverse selection because low-risk individuals may decide to forgo insurance altogether, due to the high premium costs. In extreme cases, an insurance market can collapse due to a lack of low-risk policyholders - an unstable market with only high-risk individuals is unsustainable.

Demonstrate Adverse Selection in Insurance Market

Let's illustrate with a simple example: An insurance company offers a health insurance policy without any prior medical examination. Two different groups of individuals are interested in buying health insurance: a high-risk group (Group H) and a low-risk group (Group L). Group H has a 70% chance of getting sick, while Group L has only a 30% chance of getting sick. If the insurance company charges the same premium to both groups, the high-risk individuals will be more likely to purchase insurance, as they have a higher likelihood of needing to use the insurance coverage. This will lead to an imbalance in the market as the proportion of high-risk policyholders will increase.

Adverse Selection Spiral

As the proportion of high-risk policyholders in the insurance market increases, the insurance company will experience more claims and will be forced to increase premiums to cover the higher claim costs. This, in turn, will cause more low-risk individuals to leave the market, worsening the insurer's risk pool even further. This feedback loop between high-risk individuals and the increase in premiums is sometimes referred to as an "adverse selection spiral".

Potential Solutions to Adverse Selection

To mitigate the effects of adverse selection, insurance companies may implement various strategies, such as requiring more detailed information about the risk factors of potential policyholders, including medical examinations, and differentiating premiums based on the risk levels of individuals. Government regulations or subsidies may also help address adverse selection by promoting transparency or providing incentives for low-risk individuals to purchase insurance.