Containing the Promise of Insurance: Adverse Selection and Risk Classification

This essay extends to adverse selection the critical attention provided in prior work to moral hazard. Like moral hazard, adverse selection is an old insurance concept that was adopted, formalized, and generalized by economists developing the economics of information. As with moral hazard, insurance economics has addressed the phenomenon of adverse selection largely from the insurers' point of view. This essay examines how insurers create and shape adverse selection. At least in the context of insurance risk classification, there is much to be gained in thinking of adverse selection as a 'dual' problem (similar to moral hazard), meaning that actions to address adverse selection problems can lead to the de-pooling effect that motivated the actions in the first place. The first part of the essay sets forth the case for understanding adverse selection as a dual problem and highlights alternatives to insurance risk classification. The second uses three historical examples to explore moral justification for insurance risk classification. The three examples are the 19th century controversy over age-based pricing in fraternal insurance, the mid 20th century controversy over experience rating in unemployment insurance, and the late 20th century controversy over efforts to exclude battered women from life, health and disability insurance pools. These examples demonstrate that, rather than being a neutral, technical solution to a structural dynamic inherent in the insurance relationship, risk classification reflects moral commitments.