The insurance industry relies to a certain degree on "good faith practices" when accepting a policyholder's word regarding her circumstances or conditions. Adverse selection occurs when policyholders misrepresent themselves during the underwriting process. These misrepresentations cause a ripple effect that influences the insurance company's profits as well as its other policyholders.
The insurance underwriting process is designed to help insurers measure risk factors and determine cost values based on the amount of risk present. In effect, risk factors act as guidelines for setting premium rates and coverage amounts as well as other conditions associated with a policy. If an insurance company has no knowledge of existing risk factors within a certain group of policyholders, the company ends up paying out more in claims than expected. This group of policyholders results from a process called adverse selection where a particular policy or plan attracts a certain type of policyholder.
The risk measurements made by insurance companies are based on the information received from policyholders. Making insurance available to diverse groups of people with varying risk factors prompts those who carry the greatest risk to buy into an insurance plan, according to Money Terms, a financial management resource site. As a result, adverse selection processes develop when those with the most risk factors withhold information regarding their condition in an attempt to obtain insurance coverage.
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Since insurance companies specialize in balancing risk with profits and costs, policyholders who carry the most risk factors pay the highest premiums while those with few to no risk factors pay the lowest premiums. According to Health Insurance Info, the unexpected claims payout that results from adverse selections requires insurance companies to raise premium rates across the board. This prompts many low-risk policyholders to drop their coverage, which in turn leads to another premium rate hike to make up for loss of policyholders. This process can repeat itself--with more and more low risk policyholders dropping out--until only high risk policyholders are left.
To reduce the effects of adverse selection, insurance companies take certain protective measures that appear within their eligibility requirements, pricing rates and coverage options. Eligibility and coverage options may appear as exclusionary clauses, such as when health insurers exclude coverage for pre-existing conditions or impose a waiting period before covering a pre-existing condition. In the case of pricing measures taken, insurers can charge higher premium rates based on statistical information, according to Money Terms. An example of this is how auto insurers tend to charge higher premium rates for certain types of drivers or certain models of vehicles.
In some cases, an insurance company may take aggressive steps to avoid the likelihood of adverse selection by designing specialized plan types, according to Health Insurance Info. This practice is known as "cherry picking," or "cream skimming." In effect, insurers design a policy plan that attracts low risk individuals based on statistical information gathered on a certain population group. As a result, insurers can advertise low premium rates to entice enrollees. Insurers still make a profit because of low claims rates, which enable them to maintain low premium rates and keep their existing policyholders