Adverse selection is an important term in the economics of insurance. It sounds strange, but adverse selection describes a situation where the people who “select” to apply for insurance coverage are those who have knowledge that they are likely to need and use the insurance. Insurance involves the pooling of risks. A diverse set of independent risks is a fundamental requirement for a successful pool. In other words, a health insurance pool cannot consist entirely of people who are ill—there must be healthy people paying premiums to offset those who are filing claims. Similarly, a successful annuity pool cannot consist only of those who are in perfect health and are likely to live to 100 years of age. The insurance pooling mechanism will fail if the pool only consists of those who are highly likely to use the insurance. Insurance companies use underwriting as a tool to address adverse selection. In other words, the insurance company will ask a bunch of question up front in order to better understand the private information the applicant might have about their circumstances. Asymmetric information is a glossary term related to adverse selection.
