Insurance and adverse selection: orthodoxy
Written by: Guy Thomas
Guy Thomas explores why adverse selection in insurance is usually seen as a bad thing in the first of two blog posts based on his new book Loss Coverage.
Discrimination is the taboo of our times. We often feel that it is unfair for a person’s treatment to be determined by personal characteristics which have often been used in oppressive ways, and which are not perfectly predictive and which we do not choose. This sentiment is vaguely specified and inconsistently applied, but it is also pervasive, and now deeply embedded in our law and culture.
The insurance industry has traditionally claimed a degree of exemption from this sentiment. Anti-discrimination laws usually include exemptions for insurance pricing. The rationale for these exemptions is an economic phenomenon known as ‘adverse selection’. This blog recounts the orthodox argument; my next blog will summarise the counter-argument advanced in book Loss Coverage.
To provide context, think of life insurance, where people can be usually be divided into two broad risk-groups, one higher risk and one lower risk. If insurers can, they will charge risk-differentiated prices to reflect the different risks.
Suppose instead that insurers are banned from differentiating between higher and lower risks, and have to charge a single ‘pooled’ price for all risks. A pooled price equal to the simple average of the risk-differentiated prices will seem cheap to higher risks and expensive to lower risks. Higher risks will buy more insurance, and lower risks will buy less.
To break even, insurers will then need to raise the pooled price above the simple average of the risk-differentiated prices. Also, since the number of higher risks is typically smaller than the number of lower (or ‘standard’) risks, higher risks buying more and lower risks buying less implies that the total number of people insured will fall.
This combination of a rise in price and a fall in demand is adverse selection. It is usually portrayed as a bad outcome, for both insurers and society.
But from a social perspective, it is arguable that higher risks buying more is a good thing; after all, the higher risks are those more in need of insurance! Also, the compensation of losses by insurance is generally seen as a good objective, which public policymakers often seek to promote, by public education, by exhortation and sometimes by incentives such as tax relief on premiums. Insurance of one higher risk contributes more in expectation to this objective than insurance of one lower risk. This suggests that public policymakers should welcome higher buying by higher risks, except for the usual story about adverse selection.
Fortunately the usual story about adverse selection has a flaw, which I will describe in my next blog.