When insurance is sold, insurers must deal with the problem of adverse selection. Adverse selection is the tendency of persons with a higher than average chance of loss to seek insurance at standard rates, which is not controlled by underwriting; results in higher than expected loss levels. For example; adverse selection can result from high-risk drivers who seek auto insurance at standard rates, from persons with serious health problems who seek life or health insurance at standard rates, and form business firms that have repeatedly been repeatedly robbed or burglarized and seek crime insurance at standard rates. If the applicants for insurance with a higher-than-average chance of loss succeed in obtaining the coverage at standard rates, we say that the insurer is adversely selected against. If not controlled by underwriting, adverse selection can result in higher than expected loss levels.
Adverse selection can be controlled by careful underwriting. Underwriting refers to the process of selecting and classifying applicants for insurance, insured at standard or preferred rates. If the underwriting standards are not met, the insurance is denied, or an extra premium must be paid, or the coverage offered may be more limited. Insurers frequently sell insurance to applicants who have a higher than average chance of loss, but, such applicants must pay higher premiums. The problem of adverse selection arises when applicants with a higher than average average chance of loss succeed in obtaining the coverage at standard or average rates.
Policy provisions are also used to control adverse selection. Examples are the suicide clause in life insurance and the preexisting conditions clause in individual medical expense policies prior to enactment of the Affordable Care Act, also known as the ‘Obamacare’. These policy are discussed in greater detail later in the text when specific insurance contracts are analyzed.
Insurance and Gambling Compared; Insurance is often confused with gambling. There are two important differences between them. First, gambling creates a new speculative risk, while insurance is a technique for banding on already existing the risk. The second difference between insurance and gambling can be socially unproductive, because the winner’s gain comes at the expense of loser. In contract, insurance is always socially productive because neither the insurer or the insured is placed, in a position where the gain of the winner comes at the expense of the loser. Both the insured and the insurer have a common interest in the prevention of loss. Both parties win if the loss does not occur. Moreover, frequent gambling transactions generally never restore the losers to their former financial position. In contrast, insurance contracts restore the insureds financially in whole or in part if a loss occurs.
Insurance and Hedging Compared; We know that hedging is a condition by which risk can be transferred to a speculator through the purchase of a futures contract. An insurance contract,however, is not the same thing as hedging. Although both the techniques are similar in that risk is transferred by a contract, and no new risk is created, there are some important differences between them. First, an insurance transaction typically involves the transfer of pure risks because the characteristics of insurable risk generally can be met. However hedging is a technique for handling speculative risks that may be uninsurable such as protection against a decline in the price of agricultural products and raw materials.
A second difference between insurance and hedging is that insurance can reduce the objective-risk of an insurer by an application of the law of large numbers. As the number of exposure units increases, the insurer’s prediction of future losses improves because the relative variation of actual loss from expected loss will decline. Thus, many insurance transactions reduce objective risk. In contrast, hedging typically involves only risk transfer, not risk reduction. The risk of adverse price fluctuations is transferred to speculators who believe they can make a profit because of superior knowledge of market conditions. The risk is transferred, not reduced and prediction of loss generally is not based on the law of large numbers.
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