Life & Health Insurance Practice Exam

What is the result of adverse selection for insurance companies?

1. Increased premiums for all policyholders

2. Higher likelihood of paying out claims

3. Improved service for policyholders

4. Reduction in the number of policyholders

The correct answer is: Higher likelihood of paying out claims

Adverse selection occurs when individuals who perceive themselves to be at a higher risk of experiencing a loss are more likely to purchase insurance than those who consider themselves at lower risk. As a result, insurance companies often face a higher proportion of high-risk policyholders in their overall portfolio. This situation leads to an increased likelihood of having to pay out more claims than anticipated, as the pool of insured individuals predominantly consists of those most likely to make a claim. Consequently, the higher claims result from the insurance company having a less optimal risk pool. In this context, the correct answer highlights the financial impact of this phenomenon on the insurers. Instead of a balanced mix of low and high-risk policyholders, adverse selection skews the risk assessment in favor of claims being more frequent, as higher-risk individuals are overrepresented. This can ultimately threaten the insurer’s profitability, as payouts may exceed the collected premiums. The other options reflect potential outcomes that do not stem directly from the concept of adverse selection or are less accurate in representing its consequences. For instance, while higher premiums for all policyholders might eventually result from the need to offset losses due to adverse selection, it is a secondary effect rather than a direct consequence.