Question

1. The expected losses must depend on the insured’s behavior BEFORE the policy is signed
2. The expected losses must depend on the insured’s behavior AFTER the policy is signed
3. It must be costly for the insurer to observe policyholder type

The conditions necessary for adverse selection to arise in insurance contracts are:

Answer 1

As an Insurance Policy seller, it is very importatn to guage the Policy Buyers behaviour since many people try to manipulate the contract to make money. So it is very important for the Seller to avoid adverse selection of Policy Holders since that might cause a huge loss to the Policy Sellers / Insurance Company.

The expected Loss must depend upon the insured's behaviour after the policy is signed, since it is post that the policy holder feels secure and tries to work his way around to get the claim from the insurance company. It is on the other hand very hard for the insurer to guage the policy holder type since they cannot know everything about a person. They have to go by their words and reports both of which can be manipulated.

So an insurer must be very much aware of the possible adverse scenarios that might arise and guage through accordingly.