State Farm Insurance License Practice Exam

What defines adverse selection in insurance?

1. The insurer selecting only low-risk clients

2. The tendency of insureds with a higher chance of loss to purchase insurance

3. The ability of the insurer to forecast risk accurately

4. The avoidance of high-risk policyholders by insurers

The correct answer is: The tendency of insureds with a higher chance of loss to purchase insurance

Adverse selection occurs in the insurance market when individuals who are at a higher risk of experiencing a loss are more likely to seek insurance coverage compared to those who are healthier or at lower risk. This phenomenon can lead to a disproportionate number of high-risk individuals in an insurer's pool of policyholders. As a result, insurers may face greater claims than anticipated, which can lead to increased premiums or losses for the company. In this context, the correct definition captures the essence of adverse selection, emphasizing that it is the elevated likelihood of higher-risk individuals opting for insurance that contributes to the issue. This can create a situation where the insurance pool is unbalanced, with higher cumulative risks, leading insurers to adjust their pricing or coverage offerings in response. Understanding this concept is crucial for those entering the insurance field, as managing adverse selection is vital for maintaining a stable and profitable insurance operation. The other options, while related to risk management and selection, do not accurately capture the core issue of adverse selection itself.