South Dakota Crop Insurance Practice Exam

What does adverse selection indicate in the context of insurance?

1. High demand by low-risk individuals

2. High-risk individuals seeking coverage

3. Low premiums for all insureds

4. Minimizing overall risk exposure

The correct answer is: High-risk individuals seeking coverage

Adverse selection refers to a situation where individuals with a higher-than-average risk are more likely to seek insurance coverage compared to those with a lower risk. This occurs because high-risk individuals are often more in need of insurance protection, making them more inclined to purchase policies. Consequently, if an insurance company cannot accurately assess risk and charge premiums accordingly, it may end up with a pool of insured individuals that is skewed toward those who are more likely to file claims. This imbalance can lead to financial losses for the insurer, as the premiums collected may not be sufficient to cover the claims made by the high-risk pool. The result can drive up premiums for all insureds over time if not managed correctly. In this context, the high concentration of high-risk individuals seeking insurance is at the core of adverse selection, making the identification of this phenomenon crucial for insurance companies to maintain their profitability and sustainability.