Life & Health Insurance Practice Exam

What is adverse selection in the context of insurance?

1. The tendency for healthier individuals to seek insurance

2. The likelihood of people in poor health buying and retaining insurance

3. The principle of shared risk in insurance

4. The process of underwriting insurance policies

The correct answer is: The likelihood of people in poor health buying and retaining insurance

Adverse selection refers to the phenomenon where individuals who are at a higher risk of needing insurance coverage are more likely to purchase insurance than healthier individuals. This creates an imbalance in the insurance pool, leading to a situation where the insurer's risk significantly increases because those most likely to require claims are the ones who are insuring themselves. Individuals who are in poorer health or who have a higher likelihood of incurring significant medical costs are often more motivated to secure insurance. This means that the insurance company could end up with a disproportionate number of high-risk policyholders, which can ultimately lead to higher premiums for everyone and potential financial instability for the insurer. On the other hand, healthier individuals may feel less inclined to purchase insurance as they perceive a lower risk of needing medical services, which contributes to the problem of adverse selection. Understanding this concept is crucial in insurance underwriting and pricing, as insurers strive to create a balanced and fair risk pool to ensure their sustainability and profitability.