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Theory of Adverse Selection

The term ‘adverse selection’ is a term used on economics, risk management, and insurance. The theory of adverse selection states that when buyers and sellers have access to different information, bad results are likely to occur. Bad results occur when the buyers select the bad products/services and the sellers go ahead and sell the bad products/services to the buyers. In insurance, the term adverse selection’ refers to a situation where the demand for insurance by individuals relates positively with the individuals’ risk of loss but the insurers are unable to price of insurance in such a manner that the insurance price reflects the level of risk of the insured. For example, an individual who is aware that he will not live for along time fails to disclose this to the insurer and goes ahead to purchase life insurance, which is priced to reflect the average risk of death of the general population. Such as individual purchases this insurance because the price of the insurance appears favorable to him. On the other hand, a individual who is aware is likely to live for a long time than an average individual fails to purchase a life insurance, whose price reflect the average risk of death of the general population because such insurance is not a good deal to him.

Adverse selection in insurance occurs when individuals have access to private information, which the insurers do not have. It also occurs because of existence of regulations in the insurance industry, which prohibit insurers from using certain category of information to fix insurance price. Such categories of information include results of genetic test, ethnicity, gender, or pre-existing medical conditions. According to Siegelman (2004), when adverse selection is allowed in insurance, and prohibitions are put in place to prevent insurers from fixing insurance price based on certain category of information, then losses occur when an individual suffers, and the suffering is associated with the category of information that the insurer was prohibited from using to fix the insurance price. In fact, 100 percent risk of losses prevails in treatment of conditions with pre-existing medical conditions.

In order to counter the effects of adverse selection, economists are advocating for passing of a law that states that insurance companies should not discriminate based on pre-existing conditions. However, this law must be accompanied by a requirement that everyone must get health insurance. The none-discrimination based on pre-existing medical conditions requirement is to allow individuals with pre-existing medical conditions to gain access to affordable medical insurance thus, avoiding the risk of experiencing 100 percent losses of their health insurance when they suffer from, and are treated for conditions related to pre-existing medical conditions. At the same time, the requirement that all individuals should get health insurance is to safeguard the insurance market from collapsing (Siegelman, 2004). This is because the average population (with low death risk compared to individuals with pre-existing conditions) may fail to get health insurance because the prices offered by the insurance companies may appear bad deals to them but good deals to individuals with pre-existing medical conditions. Similarly, individuals with pre-existing medical conditions may fail to get health insurance because they may tend to view the prices offered by insurance companies as bad deals to them but good deals to the average population. If this occurs, the number of individuals buying health insurance may be too little to support the insurance market. This is why economist are arguing that if a law that prohibit insurance companies from discriminating on the basis of pre-existing conditions is passed, then it should be a requirement that every individual must get health insurance.

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