A few examples will make things clear.
Health Insurance :-- An individual knows best about his or her health. If he feels that there is very high probability that he will fall sick than he is tend towards taking health insurance. This is ANTI SELECTION or adverse selection if an insurer is not able to differentiate this risk from rest of the pool.
Lets see a bit more exhaustive example.
Motor Insurance :-- Suppose we have only two cars in market ( SANTRO and INDICA ). Company A insures 50 santro cars and 50 indica cars. Company collects Rs 1000 per car. Hence total revenue for the company is Rs 100000. Company recorded a total 16 claims and average claim size being Rs 5000. Therfore total claims is of Rs 80000 and Company makes a profit of Rs 20000.
A more detail analysis shows out of these 16 claims 11 came from Indica and 5 came from Santro. ( for simplicity lets keep avg claim cost constant ).
Company B when looked at the scenario priced its product in different fashion. Prices for indica was Rs 1500 and prices for Santro as Rs 750.
Company A sticks to their old pricing. All the Santro holders shited from company A to company B and all Indica holders taken policies from company A.
Aftereffects :-- Company A has 150 policies ( cars ) all Indica. Collected Rs 150000 as Premium . There were 33 claims of Rs 5000 and totalling Rs 1,65,000 . Company makes a loss of Rs 15000.
This is the effect of Adverse Selection.
Actuaries and Underwriters combine their skills together to eliminate this kind of effect to take place. Actuaries have the mathematical skills to identify the bad and good areas. Underwriters have knowledge of Market and competitors.
We ( actuaries ) have to price our product in such a manner that such effect does not take place in Market. Constant monitoring is also necessary to identify such Burning spots and to remove them with immediate effect.
More on this later.
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