South Carolina Life Insurance Practice Exam

What is a key consequence of adverse selection for insurance companies?

1. Increased losses

2. Lower premiums

3. Increased profitability

4. Reduced application errors

The correct answer is: Increased losses

Adverse selection refers to a situation in insurance where individuals with higher risks are more likely to apply for insurance coverage than those with lower risks. This can lead to a pool of insured individuals that is riskier than the general population, possibly resulting in higher claims than the insurer initially anticipated. Consequently, for insurance companies, one of the primary consequences of adverse selection is increased losses. When a disproportionate number of high-risk individuals are insured, the insurer faces greater claims payouts. This can severely impact their financial stability, as reserves set aside for claims may not be sufficient to cover the actual costs incurred. Therefore, insurers may need to raise premiums for all policyholders in order to offset these losses, which can further exacerbate the issue by driving away lower-risk applicants who may seek more affordable coverage elsewhere. Overall, the increased losses associated with adverse selection highlight the importance of accurate risk assessment in underwriting and the need for insurance companies to implement measures that can help mitigate this risk, such as careful screening and collecting comprehensive data on applicants.