Adverse selection occurs when...

Adverse selection occurs when...

• A. Those with lower risk seek insurance most aggressively.
• B. Those at greater-than-average risk are more likely to seek insurance.
• C. Insurance companies underwrite to equalize risk.
• D. Policies are uniformly priced regardless of risk.

Answer: (B)

Adverse selection happens when those at greater-than-average risk are more likely to seek and obtain insurance. This occurs because applicants know their own risk level better than the insurer, and if prices don’t reflect that risk adequately, the insured pool becomes skewed toward higher-risk individuals. As a result, claims costs rise, premiums may need to increase, and the market can become unstable. The other statements describe related ideas but not the phenomenon itself: lower-risk individuals being the ones who seek insurance aggressively would be favorable selection, not adverse. Underwriting to equalize risk is a practice used to counter adverse selection, not define it. Uniform pricing regardless of risk would remove price signals that help separate risk levels, which would worsen adverse selection in practice, but it’s not the definition of adverse selection.

Adverse selection happens when those at greater-than-average risk are more likely to seek and obtain insurance. This occurs because applicants know their own risk level better than the insurer, and if prices don’t reflect that risk adequately, the insured pool becomes skewed toward higher-risk individuals. As a result, claims costs rise, premiums may need to increase, and the market can become unstable.

The other statements describe related ideas but not the phenomenon itself: lower-risk individuals being the ones who seek insurance aggressively would be favorable selection, not adverse. Underwriting to equalize risk is a practice used to counter adverse selection, not define it. Uniform pricing regardless of risk would remove price signals that help separate risk levels, which would worsen adverse selection in practice, but it’s not the definition of adverse selection.