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Next time you think a prospective carrier is asking you too many personal questions on its form consider the issue of adverse selection.

Adverse selection is a concept that appears in economics and logic textbooks. In the insurance universe it describes a situation in which a person with great insurance needs is more likely to purchase a policy, without the carrier’s knowledge that that person is more risky to insure.

For example, let’s say you suffer from narcolepsy. You and your family would rightly be keen on making sure you had the maximum car insurance allowable. Many people gripe about the amount of information that car insurance carriers ask for before quoting a rate -- gender, education level, occupation, etc -- but insurers do not ask about medical conditions, let alone narcolepsy. For all they know, you’re just someone who believes in having a lot of insurance, not a driver who could fall asleep behind the wheel at any time.

From the insurer’s perspective, these self-selectors for more insurance are “adverse.” In response the carriers are forced to adjust (i.e. raise) prices across the board. This is also “adverse” from the carriers' perspective because a higher price for those who need insurance least might be enough for them to decide not to buy it at all. Finally, this is sub-optimal from a public policy standpoint as well because we don’t want people driving around without liability insurance.

Peppering you with personal questions when you first inquire is the insurers way of underwriting the policy -- insuring the insurance policy. This practice does stabilize the market a bit but it’s often thwarted on two fronts 1) a limit on the depth and scope of questions insurers are able to ask, and 2) people answering the allowable questions in a misleading fashion.

This information asymmetry -- in which the would-be policyholder has more information about his level of risk than does the carrier -- causes instability within pricing structures, which is why rates are always fluctuating and sometimes extremely difficult to nail down.

An illustration of this discrepancy was borne out in the flood insurance market. Some renters and homeowners knew extremely well that their homes were at risk for flood damage -- much better than the carriers did. Meanwhile those with little to no risk stayed away from the product all together. The market was so unstable that the National Flood Insurance Program (NFIP) was created, making the government the sole dispensary for flood insurance, only available in proscribed areas.

We don’t defend insurance carriers in all cases; we started CoverHound to vastly improve the consumer experience of getting the right coverage. But adverse selection and the instability of the insurance market is something to keep in mind next time you get frustrated with all the questions asked when you first sign up for a policy.

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