Editing Adverse selection (section)

===Insurance===
Adverse selection was first described for life insurance. It creates a demand for insurance which is positively correlated with the insured's risk of loss.<ref name="railway times" />

For example, overall, non-smokers have a much lower risk of death than smokers of the same age and sex. If the price of insurance does not vary according to smoking status, then it will be more valuable for smokers than for non-smokers. Thus smokers will have a greater incentive to buy insurance and will purchase more insurance than non-smokers. This increases the average mortality rate of the insured pool, causing the insurer to pay more claims. The insurer relies on the premiums of the healthy non-smokers to cover the costs incurred by the smokers. As more smokers purchase insurance, costs to insure them increases.<ref>{{cite journal |last1=O'Neill |first1=Siobhan |last2=Posada-Villa |first2=Jose |last3=Medina-Mora |first3=Maria Elena |last4=Al-Hamzawi |first4=Ali Obaid |last5=Piazza |first5=Marina |last6=Tachimori |first6=Hisateru |last7=Hu |first7=Chiyi |last8=Lim |first8=Carmen |last9=Bruffaerts |first9=Ronny |last10=Lépine |first10=Jean-Pierre |last11=Matschinger |first11=Herbert |last12=de Girolamo |first12=Giovanni |last13=de Jonge |first13=Peter |last14=Alonso |first14=Jordi |last15=Caldas-de-Almeida |first15=Jose Miguel |last16=Florescu |first16=Silvia |last17=Kiejna |first17=Andrzej |last18=Levinson |first18=Daphna |last19=Kessler |first19=Ronald C. |last20=Scott |first20=Kate M. |title=Associations between DSM-IV mental disorders and subsequent self-reported diagnosis of cancer |journal=Journal of Psychosomatic Research |date=March 2014 |volume=76 |issue=3 |pages=207–212 |doi=10.1016/j.jpsychores.2013.12.012 |pmid=24529039 |pmc=5129659 }}</ref>

In response, the company may increase premiums to correspond to the higher average risk. However, higher prices cause rational non-smokers to cancel their insurance as insurance becomes uneconomic for them, exacerbating the adverse selection problem. Eventually, higher prices will push out all non-smokers in search of better options, and the only people left who will be willing to purchase insurance are smokers.<ref>{{cite journal |last1=Kerschbamer |first1=Rudolf |last2=Neururer |first2=Daniel |last3=Sutter |first3=Matthias |title=Insurance coverage of customers induces dishonesty of sellers in markets for credence goods |journal=Proceedings of the National Academy of Sciences |date=5 July 2016 |volume=113 |issue=27 |pages=7454–7458 |doi=10.1073/pnas.1518015113 |pmid=27325784 |pmc=4941439 |bibcode=2016PNAS..113.7454K |doi-access=free }}</ref> The same applies to health insurance.

To counter the effects of adverse selection, insurers may require premiums that reflect the customer's risk, distinguishing high-risk from low-risk individuals. For instance, medical insurance companies ask a range of questions and may request medical or other reports on individuals who apply to buy insurance. The premium can be varied accordingly, and any unacceptably high-risk individuals are rejected (''cf.'' [[pre-existing condition]]). This risk selection process is part of [[underwriting]]. In many countries, insurance law incorporates an "utmost good faith" or ''[[uberrima fides]]'' doctrine, which requires potential customers to answer any questions asked by the insurer fully and honestly. Dishonesty may be met with refusals to pay claims.

Adverse selection can also result from government regulations prohibiting insurers from setting prices based on certain information. This is sometimes referred to as "regulatory adverse selection".<ref>{{cite journal |last1=Polborn |first1=Mattias K. |last2=Hoy |first2=Michael |last3=Sadanand |first3=Asha |title=Advantageous Effects of Regulatory Adverse Selection in the Life Insurance Market |journal=The Economic Journal |date=1 January 2006 |volume=116 |issue=508 |pages=327–354 |doi=10.1111/j.1468-0297.2006.01059.x |s2cid=154501669 |doi-access= }}</ref> For instance, the US government enacted the Affordable Care Act (ACA) which prohibits insurers from charging higher prices based on pre-existing conditions and gender.<ref name=":0">{{cite journal |last1=Orentlicher |first1=David |title=Cost Containment and the Patient Protection and Affordable Care Act |journal=FIU Law Review |date=22 September 2010 |volume=6 |issue=1 |doi=10.25148/lawrev.6.1.7 |doi-access=free |url=https://scholars.law.unlv.edu/cgi/viewcontent.cgi?article=2103&context=facpub }}</ref> To help prevent adverse selection, the ACA was designed with a risk adjustment programme to compensate insurers with sicker enrollees.<ref>{{cite journal |last1=Kautter |first1=John |last2=Pope |first2=Gregory |last3=Keenan |first3=Patricia |title=Affordable Care Act Risk Adjustment: Overview, Context, and Challenges |journal=Medicare |date=2014 |volume=4 |issue=3 |pages=E1–E11 |doi=10.5600/mmrr.004.03.a02 |pmc=4214269 |pmid=25364625 }}</ref> The ACA also required US residents to enroll in healthcare coverage or pay a tax penalty. This was in place to ensure enrollment by healthy individuals, even though they are less likely to claim and thus they may not otherwise have considered the coverage to be financially worthwhile.<ref name=":0" />

Empirical evidence of adverse selection is mixed. Several studies investigating correlations between risk and insurance purchase have failed to show the predicted positive correlation for life insurance,<ref>{{cite journal |last1=Cawley |first1=J. |last2=Philipson |first2=T. |title=An Empirical Examination of Barriers to Trade in Insurance |journal=[[American Economic Review]] |volume=89 |issue=4 |year=1999 |pages=827–846 |jstor=117161 |doi=10.1257/aer.89.4.827|s2cid=153756802 |url=http://www.nber.org/papers/w5669.pdf }}</ref> auto insurance,<ref>{{cite journal |last1=Chiappori |first1=P. A. |last2=Salanie |first2=B. |year=2000 |title=Testing for Asymmetric Information in Insurance Markets |journal=[[Journal of Political Economy]] |volume=108 |issue=1 |pages=56–78 |doi=10.1086/262111 |citeseerx=10.1.1.470.5388 |s2cid=55976555 }}</ref><ref>{{cite journal |last1=Dionne |first1=G. |last2=Gouriéroux |first2=C. |last3=Vanasse |first3=C. |year=2001 |title=Testing for Evidence of Adverse Selection in the Automobile Insurance Market: A Comment |journal=Journal of Political Economy |volume=109 |issue=2 |pages=444–453 |doi=10.1086/319557 |s2cid=154681165 }}</ref> and health insurance.<ref>{{cite journal |last1=Cardon |first1=J. H. |last2=Hendel |first2=I. |title=Asymmetric information in health insurance: evidence from the National Medical Expenditure Survey |year=2001 |journal=RAND Journal of Economics |volume=32 |issue=3 |pages=408–427 |jstor=2696362 |pmid=11800005 |s2cid=23645181 }}</ref>  On the other hand, "positive" test results for adverse selection have been reported in health insurance,<ref>{{cite journal |last1=Cutler |first1=David M. |last2=Zeckhauser |first2=Richard J. |title=Adverse Selection in Health Insurance |journal=Forum for Health Economics & Policy |date=1 January 1998 |volume=1 |issue=1 |doi=10.2202/1558-9544.1056 |url=http://www.nber.org/papers/w6107.pdf }}</ref> long-term care insurance,<ref>{{cite journal |last1=Finkelstein |first1=A. |last2=McGarry |first2=K. |year=2006 |doi=10.1257/aer.96.4.938 |title=Multiple dimensions of private information: evidence from the long-term care insurance market |journal=American Economic Review |volume=96 |issue=4 |pages=938–958 |pmc=3022330 |jstor=30034325 |pmid=21253439}}</ref> and annuity markets.<ref>{{cite journal |last1=Finkelstein |first1=A. |last2=Poterba |first2=J. |doi=10.1086/379936 |title=Adverse selection in insurance markets: policyholder evidence from the UK annuity market |journal=Journal of Political Economy |volume=112 |issue=1 |year=2004 |pages=183–208 |s2cid=14608232 |url=http://www.nber.org/papers/w8045.pdf }}</ref>

Weak evidence of adverse selection in certain markets suggests that the [[underwriting]] process is effective at screening high-risk individuals. Another possible reason is the negative correlation between [[risk aversion]] (such as the willingness to purchase insurance) and risk level (estimated beforehand based on hindsight observation of the occurrence rate for other observed claims) in the population. If risk aversion is higher among lower-risk customers, adverse selection can be reduced or even reversed, leading to "advantageous" selection.<ref>{{cite journal|last=Hemenway|first=D.|year=1990|title=Propitious selection|journal=[[Quarterly Journal of Economics]]|volume=105|issue=4|pages=1063–1069|doi=10.2307/2937886|jstor=2937886|doi-access=free}}</ref><ref>{{cite journal|last1=De Meza|first1=D.|last2=Webb|first2=D. C.|s2cid=55494801|year=2001|title=Advantageous selection in insurance markets|journal=RAND Journal of Economics|volume=32|issue=2|pages=249–262|jstor=2696408}}</ref> This occurs when a person is both less likely to engage in risk-increasing behaviour are more likely to engage in risk-decreasing behaviour, such as taking affirmative steps to reduce risk.

For example, there is evidence that smokers are more willing to do risky jobs than non-smokers.<ref>{{cite journal |last1=Viscusi |first1=W. K. |last2=Hersch |first2=J. |doi=10.1162/00346530151143806 |title=Cigarette smokers as job risk takers |journal=Review of Economics and Statistics |volume=83 |issue=2 |year=2001 |pages=269–280 |hdl=1803/6284 |s2cid=14973680 |hdl-access=free }}</ref>  This greater willingness to accept risk may reduce insurance policy purchases by smokers.

From a public policy viewpoint, some adverse selection can also be advantageous. Adverse selection may lead to a higher fraction of total losses for the whole population being covered by insurance than if there were no adverse selection.<ref>{{cite journal |last=Thomas |first=R. G. |year=2008 |title=Loss coverage as a public policy objective for risk classification schemes |journal=Journal of Risk & Insurance |volume=75 |issue=4 |pages=997–1018 |doi=10.1111/j.1539-6975.2008.00294.x |citeseerx=10.1.1.554.1037 |s2cid=53647253 }}</ref>