To reduce adverse selection, insurance providers try to screen out good insurance risks from poor ones. Effective information collection procedures are therefore an important principle of insurance management.
When you apply for auto insurance, the first thing your insurance agent does is ask you questions about your driving record (number of speeding tickets and accidents), the type of car you are insuring, and certain personal matters (age, marital status). If you are applying for life insurance, you go through a similar grilling, but you are asked even more personal questions about such things as your health, smoking habits, and drug and alcohol use. The life insurer even orders a medical evaluation (usually done by an independent company) that involves taking blood and urine samples. Just as a bank calculates a credit score to evaluate a potential borrower, the insurers use the information you provide to allocate you to a risk class—a statistical estimate of how likely you are to have an insurance claim. Based on this information, the insurer can decide whether to accept you for the insurance or to turn you down because you pose too high a risk and thus would be an unprofitable customer.
Charging insurance premiums on the basis of how much risk a policyholder poses for the insurance provider is a time-honored principle of insurance management. Adverse selection explains why this principle is so important to insurance company profitability.
To understand why an insurance provider finds it necessary to have risk-based premiums, let's examine an example of risk-based insurance premiums that at first glance seems unfair. Harry and Sally, both college students with no accidents or speeding tickets, apply for auto insurance. Normally, Harry will be charged a much higher premium than Sally. Insurance providers do this because young males have a much higher accident rate than young females. Suppose, though, that one insurer did not base its premiums on a risk classification but rather just charged a premium based on the average combined risk for males and females. Then Sally would be charged too much and Harry too little. Sally could go to another insurer and get a lower rate, while Harry would sign up for the insurance. Because Harry's premium isn't high enough to cover the accidents he is likely to have, on average the insurer would lose money on Harry. Only with a premium based on a risk classification, so that Harry is charged more, can the insurance provider make a profit.