The Meaning of Adverse Selection and Moral Hazard

If you work in insurance, you’re certain to come across the terms adverse selection and moral hazard. These concepts describe key problems within the industry, and although they have complicated-sounding names that many native speakers don’t know the meaning of, they’re actually pretty easy to understand.

Adverse Selection

Adverse selection occurs when a sale is being made, and either the buyer or seller knows something that the other does not. If I sell you my nice, shiny car for $15,000, but you don’t know the engine is broken, that is an example of adverse selection. Similarly, if I sell you the car for the same amount, but you know it’s a classic car worth $100,000 (and I don’t know that), then it’s also adverse selection. This phrase should be easy to remember, because adverse means something that is against your interests, and selection means a choice. Adverse selection comes about when there is imperfect information, just like in the two examples above. This mismatch in knowledge is also called asymmetric information.

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In the insurance industry, adverse selection has a slightly different meaning, but it’s based on the same principle. The term is used to describe the tendency for people with dangerous jobs and risky lifestyles to be more likely to buy insurance. Imagine two people who are married with children: one is a kindergarten teacher, the other is a stunt driver for a movie company. Which person is more likely to fear dying at work and leaving their family with nothing? Probably the stunt driver. For this reason, s/he is more likely to buy life insurance than the kindergarten teacher, and the stunt driver is also more likely to die doing their job. Because of this, insurance companies are more likely to attract customers who will make insurance claims in the future. Likewise, smokers are more likely to buy life insurance than non-smokers because of their lower life expectancy. Insurance companies prefer not to make payments, so both of these examples are situations of adverse selection in the insurance industry.

Moral Hazard

pickpocket

Moral hazard illustrates the tendency of people to take less care when they are protected against risk. A woman on holiday without insurance is probably very protective of her belongings, because if her iPhone gets snatched on the beach, she’ll have to pay a few hundred dollars for a new one when she gets back. The man lying on a towel a few yards away from her who has extensive insurance coverage will probably take more risks. What if someone takes his phone when he’s swimming in the sea? Not a problem. He’ll simply make a claim and get reimbursed from his insurers. This is another problem for insurance companies: the people who buy their policies are less likely to take care of themselves and their property and therefore have a higher likelihood of falling ill or becoming a victim of crime. This is moral hazard.

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