What it is:
Adverse selection refers to an insurance company's coverage of life insurance applicants whose risk as policyholders, due to their way of life, is significantly higher than the company perceives.
How it works/Example:
Insurance companies grant life insurance coverage to applicants on the basis of such factors as age, health condition, and occupation. Policyholders are granted levels of coverage in return for a periodic (usually annual) cost called a premium. In order to compensate the company for the increased exposure from higher-risk policyholders, premiums rise commensurately with the risks associated with an applicant's age, health condition, and lifestyle.
In adverse selection, life insurance applicants successfully foil a company's evaluation system in order to obtain higher coverage at lower premiums. This is accomplished by withholding or providing false information so that the applicant is characterized as being a significantly lower risk than in reality. For instance, if an applicant, in an attempt to pay a lower premium, manages to veritably report that he works in a one-story office when, in truth, he is a large-scale construction worker, the insurance company would be making an adverse selection by approving his application.
Why it matters:
Called as such in reference to its adverse effects on an insurance company, adverse selection unknowingly opens insurance providers to high amounts of risk exposure without fair premium compensation. Insurers are advised to verify the legitimacy of information on applications as well as to place ceilings on coverage in order to deter applicants from falsifying and/or withholding information.