Adverse Selection and Moral Hazard in the Life Insurance Industry

Adverse selection is one of two main sorts of market failure often associated with insurance. The other is moral hazard. Adverse selection can be a problem when there is asymmetric information between the seller of insurance and the buyer. What this means is that insurance may not be profitable when buyers have better information about their risk of claiming than does the insurer.

Ideally, insurance premiums should be set according to the risk of a randomly selected person in the insured slice of the population (fifty-five-year-old male smokers, for instance). In practice, this means pricing based upon the average risk of that group. However, people who know they have a higher risk of claiming than the average of the group will tend to find the price attractive and buy the insurance, whereas those who have a below-average risk may tend to feel it is too expensive to be worth buying. In this case, premiums set according to the average risk will not be sufficient to cover the claims that eventually arise because, among the people who have bought the policy, more will have above-average risk than below-average risk. In general, raising the premium will not solve this problem, for as the premium rises the insurance policy will become unattractive to more of the people who know they have a lower risk of claiming. 

The concept of moral hazard is related to the fact that people with insurance may take greater risks than they would tend to take without insurance because they know they are protected. Consequently, the insurer may get more or earlier claims, on average, than expected. Insurers try to avoid these problems by requiring prospective insureds to take physical exams and by employing comprehensive underwriting procedures. They also negotiate with employers, associations, and other groups, to provide group coverage where essentially every member of the group is covered, so there is relatively little opportunity for adverse selection. 

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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