Insurance premium and Anti-selection

Anti-selection is a term not many policy holders may have heard of. But it’s something that directly affects your premium. It helps determine the cost of your insurance. Basically what is insurance, it’s about transferring you risk to an insurer against  a price called premium. The insurer upon risk transfer, will pool all similar risks and according to the size of the pool an appropriate premium for your individual risk will be calculated. So now when we know that our risk is judged relatively with the other risks of the pool. So now with this background and understanding, lets understand what is anti-selection, adverse selection. These terms stand for a particular group of people with not so good risk trying to sneak into your risk pool, by hiding some information. Do in this case what happens is the insurer doesn’t know about these bad risks and lets them be part of a better risk pool. However this will soon be reflected in the claim ratio of your risk pool and thereby in the mortality charges being levied upon you by the insurer. So you end up paying higher premiums on behalf of the bad risks in your pool.

This situation usually arises when there is information asymmetry. An insurance contract is a classic case of information asymmetry. Insurance runs on the principals of “uberrima fides” and “caveat emptor”. By “uberrima fides” is a Latin phrase which means “utmost food faith”. So in an insurance contract the insurer has to have utmost food faith on the insured, that he/she is disclosing all information that might impact insurability. The insurer would not know everything and also not know what all to ask. Although the insurance application forms that we have today , are quite comprehensive. But to disclose or not is in the hands of the insured and the insurer has to have utmost good faith in the information provided to assess the insurability wrt to the information provided. Also the insured is only bound to answer what is asked from him.

However when we talk about “caveat emptor”  which means “let the buyer be aware” it is the insurer who is responsible for letting know the insured everything. So as a buyer the insured must be in a position to make an informed decision when it comes to buying the product. So with these two principle in place a condition called information asymmetry arises, wherein the insurer has less information wrt to the insurability as compared to the insured and thus comes in picture adverse selections. Those insureds who bring in bad risks can very well hide the true facts leading to information asymmetry and there by putting the insurer in a position where they are not able to correctly assess the risk. And thus the insured ends in  a risk pool where it doesn’t belong, it pollutes the risk pool and pushes the claim ratio proportionately higher thereby increasing the cost of insurance for the better risks. Which drives away the good risks from the insured. So in a way more than the insured it’s the insurer who will feel the setback thanks to anti-selection.

So as a prudent insured we must disclose all facts to the insurance company for them to be able to assess the risk in all possible ways, Thereby leading to a better experience for both us and the insurer.

And remember if its a choice between insurance and ignorance...do choose insurance