What is adverse selection - and do I really care?

• Author: Adams, Tucker Hart
• Position: The ECONOMIST

Almost 25 years ago, I was invited to join the board of a big property and casualty insurance company, my first public company board. I learned a lot in my years on the board.

I learned that a director has a Duty of Care and a Duty of Loyalty; that it is possible to insure deadbeat drivers and golf tournaments and sand and gravel trucks, if you understand the business; that there are law firms that file frivolous (my judgment) lawsuits on "behalf" of shareholders because they know the company will settle out-of-court, and they can split the settlement.

I have a vivid memory of the latter. Another board on which I served had been sued and a group of us was being deposed, including the shareholder who had filed the suit - an old geezer from a small town somewhere in the Midwest.

[ILLUSTRATION OMITTED]

"Mr. Jones, was X Company unfair to its shareholders?" the attorney asked.

"Oh, no, no, I wouldn't say that. X was a fine company."

"But they took advantage of you and cut your dividends. Isn't that true?"

"No, I wouldn't say that. They paid dividends every quarter, just like clockwork. Made me a lot of money."

"Mr. Jones, are you telling me that you don't believe X Company took advantage of you and other shareholders?"

"Nope, never did. They're a fine company."

"Well then, Mr. Jones, why have you filed this lawsuit against X Company?"

"Why, because some lawyer from New York City called me and told me I'd make a lot of money if I did so."

But, I digress.

One thing the insurance company board spent a lot of time on was a seemingly endless discussion of adverse selection, one of the two bogeymen of the insurance industry. (The other is moral hazard - when a party insulated from risk behaves differently from one not insulated from that risk.) Adverse selection is a fairly simple concept. It refers to the proclivity of those with higher risk to purchase more insurance than those with lower risk.

Before my insurance company board. experience, I wondered why my mortgage company required me to purchase flood insurance. I live at 7,000 feet, on a Tucker Hart Adams, president of the Adams Group, monitored and analyzed the Colorado economy for 30 years. She can be reached via her website...