The insurance industry is built on the concept of risk, and more specifically sharing or pooling of risk. To illustrate, suppose 1 of every 100 automobiles insured is damaged and must be totaled, requiring the insurance company to pay the policyholder the full value of the vehicle. If all 100 automobile owners pay 1/100 of the value of their vehicle to an insurance company, then enough money will have been collected to cover the one vehicle that was damaged. (Expenses and profits are not included in this calculation). In reality, however, not all 100 individuals will carry full coverage on their vehicles. There is a tendency for those who are the most likely to have an accident to carry the greatest amount of coverage and those least likely to have an accident to carry the lowest level of insurance. This concept is known as adverse selection.Insurance companies often compensate for this discrepancy by charging a higher premium to high-risk individuals. For instance, for a life insurance policy, a smoker will pay a higher premium than a non-smoker because analysis of risk has indicated that the smoker has a higher probability of dying at an earlier age than the non-smoker. In the same way, automobile insurance will cost more in large urban areas with high accident rates such as Houston, while an insured in rural Texas will pay much less.Another method insurance companies use to deal with adverse selection is not insuring at all. Such is the case with flood insurance. Intuitively, only people who live in flood planes will buy flood insurance. Thus, flood insurance is provided by the federal government either directly or through a 100% reinsurance arrangement with a private insurer.
Earthquake insurance is similar to flood insurance in that only those policyholders in earthquake prone areas are likely to purchase the coverage. Earthquakes, however, are less frequent than floods and, therefore, private insurers are willing to provide the coverage for a higher premium than that charged for policyholders without earthquake coverage.
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US, MEDICAL:
Method or process used in a managed care contract where there is a risk of enrolling members who are sicker than assumed and may use expensive medical services more often.
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The tendency of persons with a higher than average probability of loss to seek or continue insurance to a greater extent that do persons with an average or below average probability of loss.
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When an individual who is a higher-than-average risk tries to buy insurance at the standard rate.
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UK:
The tendency of poorer than average risks to buy and maintain insurance. It occurs when insureds select only those coverages that are most likely to have losses. Insurers respond by making adverse underwriting decisions, i.e. those not favourable to the insured by termination, declining acceptance, higher rates or reduction in cover. See SELECTION OF LIVES.