Because medical records are private, an individual applying for health insurance will know more about his own health conditions than will the insurance companies to which he is applying for coverage. Is this information asymmetry likely to increase or decrease the insurance premium? Why?

Adverse selection is an issue of inadequate information that results in unprofitable terms of a contract for one party who has less or no information about the other party involved.

In the insurance industry, adverse selection results in selling life or health insurance to parties who hide their bad health situation at the time of contract. The sellers can’t identify high and low-risk buyers and sell the insurances that can lead to both profits and losses for them.

A seller of medical insurance does not have the same amount of information as the buyer has about his/her health conditions. Thus, the seller is unable to identify the potential risk associated with selling insurance.There is an asymmetry of information that puts the seller at a disadvantage. To cope with this, the premiums are set based on the probability of events that can create profits and losses for the sellers.

The payments for any bad outcome will be made from a pool of money (created using insurance premiums from both high and low-risk buyers). The presence of many high-risk buyers can lead to heavy losses. The sellers, thus, charge a high premium so that only people who are willing and able to buy such insurances can do so. We can say that asymmetry information increases the insurance premium.

For example, if a person knows about his bad health and wants to buy insurance, a higher premium will not stop him. The higher premium paid by him/her will increase the pool of money to cover the losses.