Mississippi Property & Casualty Practice Exam

What might be a consequence of adverse selection in the insurance market?

1. Lower premiums for all policyholders

2. Increased rates due to high-risk individuals

3. More policies being issued

4. Less regulation from insurance boards

The correct answer is: Increased rates due to high-risk individuals

Adverse selection occurs in the insurance market when individuals with a higher probability of filing a claim are more likely to purchase insurance than those who are at a lower risk. This typically leads to an insurer having a disproportionate number of high-risk individuals in their pool of insured, which can result in higher overall claims than anticipated. As a direct consequence of this phenomenon, insurance companies may face increased costs due to the larger number of claims made by these high-risk policyholders. To compensate for these increased costs and maintain profitability, insurers are likely to raise premiums for their policies. This not only affects those high-risk individuals but can also have a cascading effect on premiums across the board, pushing the rates higher for everyone as the insurance provider seeks to manage the financial risk associated with their portfolio of policies. The other options reflect scenarios that would generally not arise from adverse selection. For example, lower premiums or more policies issued would imply an improvement in risk pooling, while less regulation would not typically be linked to the dynamics of adverse selection.