In the case of insurance, adverse selection is the tendency of those who have hazardous jobs or high-risk lifestyles to then intend to purchase products such as life insurance. In this case, the actual buyer has more knowledge about their health. To combat adverse selection, insurers will reduce their exposure to large claims by limiting coverage or increasing premiums.
Avoiding adverse elections requires identifying groups of people who are more at risk than the general population and charging them more costs or money. For example, a life insurance company undergoes underwriting when evaluating whether to grant a policy to an applicant and how much premium to charge.
The underwriter will typically evaluate the applicant’s height, weight, current health, medical history, family history, occupation, hobbies, driving record, and the applicant’s lifestyle risks such as smoking, all of which affect the applicant’s health and the company’s potential to pay claims. The insurance company then determines whether to grant the policy to the applicant and what premium to charge for taking the risk.
Another example of adverse selection is in the case of vehicle insurance, where the applicant obtains insurance coverage by providing a residential address in an area with a very low crime rate, but on the other hand the applicant actually lives in an area with a very high crime rate. Obviously, the risk of a vehicle being stolen, vandalized, or damaged when regularly parked in a high crime area is substantially greater than if the vehicle is regularly parked in a low