Adverse selection occurs when a producer has more information about the risk of loss than does the insurer, and is better able to determine the fairness of premium rates (Harwood et al., 1999). As a result, those who are overcharged are less likely to purchase insurance, while those who are undercharged are more likely to over- purchase insurance. Over time, indemnities will exceed premiums in such markets, and raising premium rates for all insureds will potentially create an even more adversely selected market as the less-risky participants drop out of the program. More accurate risk classification reduces adverse selection problems, but risk classification, like monitoring for moral hazard, is potentially costly. Compulsory insurance coverage can mitigate.
