User:Sashw82/Adverse selection

For example, non-smokers typically live longer than smokers. 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.

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. The same can apply to insurance plans with different levels of copay, where high risk consumers are more likely to want plans with high levels of copay, resulting in larger losses for insurance companies.

To counter the effects of adverse selection, insurers may offer premiums that are proportional to a customer's risk by distinguishing high-risk individuals 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 unreasonably 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'. For instance, the U.S. government enacted the Affordable Care Act which prohibits insurers from charging higher prices based on pre-existing conditions and gender. To help prevent adverse selection, the ACA was designed with a risk adjustment program to payout insurers with sicker enrollees. The ACA also required U.S. residents to enroll in healthcare coverage or pay a tax penalty. This was in place to ensure healthy individuals enroll in coverage as healthy individuals are more likely to drop coverage.