Insurance Broker Certification Practice Exam

What term refers to the situation of insuring risks that are more prone to losses than the average risk?

1. Risk management

2. Underwriting

3. Adverse selection

4. Loss prevention

The correct answer is: Adverse selection

The correct term for the situation where risks being insured are more prone to losses than the average risk is adverse selection. Adverse selection occurs when there is an imbalance in information between the insurer and the insured, typically to the disadvantage of the insurer. In simpler terms, it refers to the tendency of those with a higher likelihood of requiring insurance coverage to be more motivated to purchase it, often leading to a concentration of high-risk individuals in an insurance pool. This can result in higher than expected claims for insurers, as they are more likely to insure clients who know they are at a greater risk. For example, if a health insurance company faces a situation where more individuals with existing health issues are applying for coverage than those who are generally healthier, it results in adverse selection. The insurer may have set premiums based on average risk without fully accounting for the higher-risk individuals entering the pool, ultimately leading to potential losses. Understanding adverse selection is crucial for insurers, as they must devise strategies to mitigate its impact, such as implementing underwriting processes that assess the risk levels more accurately or utilizing waiting periods for certain conditions.