Adverse Selection and Repeated Insurance Contracts

Adverse selection in insurance markets is defined as a problem of misallocation of resources explained by a situation of asymetrical information between the insured and the insurer. The insured has no incentive to reveal his true risk and it is costly for the insurer to observe the individual risk. In order to reduce this problem of resource allocation, insurers have developed imperfect mechanisms such as 1) the use of risk classes, 2) partial insurance coverage and 3) experience rating to establish the appropriate premium.