Posted: May 12, 2011

The Economist: What is adverse selection—and do I really care?

By Tucker Hart Adams

Almost 25 years ago, I was invited to join the board of a big property and casualty insurance company, my first public company board. I learned a lot in my years on the board.

I learned that a director has a Duty of Care and a Duty of Loyalty; that it is possible to insure deadbeat drivers and golf tournaments and sand and gravel trucks, if you understand the business; that there are law firms that file frivolous (my judgment) lawsuits on "behalf" of shareholders because they know the company will settle out-of-court, and they can split the settlement.

I have a vivid memory of the latter. Another board on which I served had been sued and a group of us was being deposed, including the shareholder who had filed the suit - an old geezer from a small town somewhere in the Midwest.

"Mr. Jones, was X Company unfair to its shareholders?" the attorney asked.
"Oh, no, no, I wouldn't say that. X was a fine company."
"But they took advantage of you and cut your dividends. Isn't that true?"
"No, I wouldn't say that. They paid dividends every quarter, just like clockwork. Made me a lot of money."
"Mr. Jones, are you telling me that you don't believe X Company took advantage of you and other shareholders?"
"Nope, never did. They're a fine company."
"Well then, Mr. Jones, why have you filed this lawsuit against X Company?"
"Why, because some lawyer from New York City called me and told me I'd make a lot of money if I did so."

But, I digress.

One thing the insurance company board spent a lot of time on was a seemingly endless discussion of adverse selection, one of the two bogeymen of the insurance industry. (The other is moral hazard - when a party insulated from risk behaves differently from one not insulated from that risk.) Adverse selection is a fairly simple concept. It refers to the proclivity of those with higher risk to purchase more insurance than those with lower risk.

Before my insurance company board experience, I wondered why my mortgage company required me to purchase flood insurance. I live at 7,000 feet, on a hilltop that our real estate agent told us is the highest point between the Rockies and the Appalachians. If I need flood insurance, the rest of you better start building an ark. But, of course, the requirement is a way to avoid adverse selection - requiring only people in flood plains to purchase the insurance would make it prohibitively expensive.

Adverse selection is very relevant to the high cost of health insurance in the U.S. and the recent legislation often referred to as Obamacare. Insurance companies worry that the only people who will buy health insurance are those who are unhealthy. The elderly and those with chronic diseases will purchase insurance, then file big claims. It's perhaps the primary reason that individual policies are so expensive.

Young, healthy individuals will opt to "go bare" (another insurance company term). I wrote a couple of years ago about my conversations with young people at my grandson's wedding, who don't purchase health insurance because "we don't get sick." The pending challenge to Obama's health insurance legislation, which claims requiring people to purchase health insurance is unconstitutional, is very troubling. I don't see any way to have affordable health insurance if those who are young and healthy can opt out, waiting until they are older and sicker to purchase insurance.

There are no simple answers to the adverse selection problem, other than insisting that everyone purchase the insurance. It's why I had to buy flood insurance when I bought my house. It's why I have to have auto insurance to license my car. And, it's why the solution to health care must require all of us, healthy or not, to purchase health insurance.
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