Adverse Selection in Insurance Markets: An Exaggerated Threat

Abstract:     
Adverse selection is the process by which insureds who know their own risk of loss take advantage of this information to choose insurance coverage in a way that works to the detriment of their insurer. This paper demonstrates that the views of law and economics scholars studying insurance, as well as policy makers and judges, have been shaped by a fear of adverse selection, a fear that I claim is overstated. After documenting the existence of these fears, I demonstrate that the empirical basis for the importance of adverse selection is limited, the economic theory underlying the phenomenon is not robust, and that there are alternative plausible theories of insureds' behavior that lead to startlingly different results. Adverse selection does sometimes occur, but it has cast too large a shadow on insurance law and regulation.

Working Paper Series