Before proceeding, we wish to stress that adverse selection has important implications
for policy and is not only of interest to economists. The theory of adverse selection has
had an important effect on insurers, government regulators, and courts.5 To illustrate,
as of August 2007, there were more than 130 state and federal opinions in U.S. courts
that discussed adverse selection, in all types of insurance markets, from pension
guarantees6 to long-term disability insurance.7 Concern about adverse selection in
health insurance has prompted courts to permit marketing practices—such as paying
downstream firms a bonus not to carry a rival’s product—that would otherwise
constitute clear antitrust violations.8 Similar concerns led the U.S. Equal Employment
Opportunity Commission to allow employers to exclude persons with disabilities
from employer-provided health insurance if the inclusion of such persons would
result in “unacceptable adverse selection.”
Given public officials’ receptivity to arguments based on the existence of adverse
selection, it is unsurprising that policy advocates have made substantial use of such
arguments. Priest (1987) argued that the U.S. insurance “crisis” of the mid-1980s,
in which certain kinds of liability insurance commanded sharp premium surges or
were withdrawn altogether, was produced by an adverse selection death spiral that
resulted from “judicial compulsion of greater and greater levels of provider thirdparty
insurance for victims. . . . ”9 Romano (1989) proposed a similar adverse selection
story to explain the “crisis” that befell the market for directors and officers liability
insurance at roughly the same time.