PSI Life Exam Practice Test

What is meant by 'adverse selection' in insurance terms?

1. Higher premiums for high-risk individuals

2. Preference for low-risk applicants only

3. Insurers losing money on high-risk policies

4. All insureds being treated the same

The correct answer is: Insurers losing money on high-risk policies

Adverse selection refers to a situation in the insurance market where individuals with a higher risk of filing claims tend to seek out insurance coverage more than those at lower risk. This occurs because high-risk individuals are more aware of their risk status and may find value in obtaining insurance to protect themselves, while low-risk individuals may opt out of insurance altogether since they perceive less need for it. In this context, when insurers write policies for high-risk individuals, they are likely to face higher claim costs, which could lead to financial losses. This dynamic can result in an insured pool that is skewed towards higher-risk individuals, causing the insurer to struggle with profitability over time. As a result, insurers must adjust their premiums and underwriting processes to account for the disproportionate risk they are taking on. While the other options touch on different aspects of insurance pricing and risk management, they do not encapsulate the core essence of adverse selection as clearly as the understanding that it leads to insurers facing losses on high-risk policies.