Blog 38: Adverse Selection by Xavier Lo, FIA, FRM, MBA

So last week we talked about moral hazard. This week’s topic is closely related, and is also very relevant to the insurance industry [保險界] (although probably useful in everyday life too). Similar to last week, let me give you a real life example then we’ll get into insurance.

Think about mobile phone contracts [手機合約] where you live. Have you ever seen contracts where they charge you money for every 1GB of data that you use? In contrast, there are other types of contracts where they charge you a monthly price for unlimited data usage [無限數據用量]. Now imagine someone who spends a lot of their time on their phones browsing the internet [上網] and using data, which contract do you think that person would choose to go with? How about someone who only uses their phone mainly for calls [淨係打電話] and never surfs the web?

The example above illustrates adverse selection [逆向選擇] very well. Basically, adverse selection is a situation where someone has more information [多資訊] than the other when in a transaction [交易]. In the example above, you would know your own data usage tendencies, but the network provider does not. That’s why it makes sense for someone who uses the internet a lot to go with a fixed-price contract.

We see this in insurance as well. Think about life insurance. In general, they would want to insure people who are active and eat healthily [健康生活飲食], but they can’t know that for sure – so you might end up having only people who are unhealthy buying the insurance product. There’s motor insurance as well. If you’re a great driver, you might not want to buy so much insurance to your car as you are confident you drive well [好駕駛者]. Hence the people who end up buying motor insurance are bad drivers.

Adverse selection and moral hazard are similar, but have their differences. Both are important concepts for us actuaries. Every time you design a product, watch out for both these things – they can be quite dangerous!

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About the Author

Xavier Lo, FIA, FRM, MBA

Qualified fellow actuary (in UK and Hong Kong), Financial Risk Manager, and MBA graduate (listed on the Dean's List) with a passion for insurance, data science, and analytics. Experienced in a broad range of insurance roles (pricing, capital modelling, reserving, ERM), along with a touch of knowledge in banking. Member of the General Insurance Committee (2021), Actuarial Innovation Committee (2019 - 2021) in ASHK.

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