South Dakota Crop Insurance Practice Exam

What phenomenon occurs when insureds desire more insurance than others, affecting the insurance company negatively?

1. Risk pooling

2. Adverse selection

3. Underinsurance

4. Overinsurance

The correct answer is: Adverse selection

The phenomenon described is known as adverse selection, which occurs when individuals with a higher risk of loss are more likely to seek out insurance coverage compared to those who pose a lower risk. This can lead to an imbalanced risk pool for the insurance company, as it ends up insuring a larger proportion of high-risk individuals. When insured parties are motivated to purchase more insurance than average due to their awareness of their greater risk—often not shared by the insurer—it can result in financial strain on the insurance company. Adverse selection undermines the fundamental premise of insurance, which relies on a distributed risk among a broad pool of policyholders. The company might face losses as they receive premiums from higher-risk individuals who are statistically more likely to file claims, resulting in a situation where the cost of claims exceeds the income from premiums. In contrast, risk pooling refers to the principle of grouping a large number of insured individuals to spread risk, while underinsurance and overinsurance deal with the adequacy of coverage rather than the selection process itself.