Property and Casualty Insurance Practice Exam

What is meant by adverse selection in insurance?

1. The selection of high-risk individuals to purchase insurance

2. The balancing of risk among policyholders

3. The practice of insurers cherry-picking low-risk clients

4. The fund allocation for future insurance claims

The correct answer is: The selection of high-risk individuals to purchase insurance

Adverse selection refers to a situation in insurance markets where individuals who are more likely to experience a loss are the ones most inclined to purchase insurance. This concept arises due to the asymmetrical information between insurers and potential policyholders; those seeking insurance typically have better knowledge of their own risk than the insurer does. When high-risk individuals secure insurance coverage, it increases the likelihood that claims will be filed, leading to greater costs for the insurer. This can create a cycle where insurers, facing higher-than-expected losses from these high-risk policyholders, may raise premiums or tighten underwriting standards. As a result, lower-risk individuals may opt out of buying insurance, further increasing the proportion of high-risk individuals within the insurance pool. This phenomenon is crucial for insurers to understand because it impacts their financial viability and market strategy. The other choices focus on different aspects of insurance operations that do not directly relate to the issue of risk selection based on knowledge asymmetry, making them less relevant in the context of defining adverse selection.