South Dakota Crop Insurance Practice Exam

What is the main consequence of adverse selection for insurance companies?

1. Lower premiums for all policyholders

2. A higher chance of loss

3. Increased market competition

4. Reduced claims processing time

The correct answer is: A higher chance of loss

Adverse selection occurs when there is an imbalance in information between the insurer and the insured. Specifically, it refers to a situation where individuals who perceive themselves to be at a higher risk of loss are more likely to purchase insurance, while those at a lower risk may choose not to buy it. The primary consequence of this phenomenon for insurance companies is a higher chance of loss. When insurers are unable to accurately assess the risk of the policyholders, they may end up with a disproportionate number of high-risk individuals, which can lead to more claims than anticipated. This, in turn, can create financial strain on the insurer, resulting in potential underwriting losses. If insurers cannot effectively balance the risk pool due to adverse selection, they may face higher overall costs and may need to adjust their premiums or coverage terms to remain financially viable. Recognizing this tendency, insurance companies often strive to gather more information and improve risk assessment methods to counter the effects of adverse selection.