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What is Adverse Selection and Why Does It Matter For Life Insurance?

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Have your insurance premiums risen unexpectedly for seemingly no reason? Perhaps you’re applying for a new policy and are having a hard time gaining coverage due to stringent application processes. In either case, the cause of the issue may not be related to you at all. 

Adverse selection is a concept with a widespread impact on the insurance industry. Learn everything you need to know about adverse selection in this helpful guide.

What is adverse selection?

Adverse selection refers to situations in which an individual withholds information when applying for insurance coverage in order to receive a lower premium than they would normally need to pay.

The concept of adverse selection is based on the assumption that individuals with a high-risk hobby, profession, or health concerns — will be more motivated to want life insurance coverage to protect loved ones. Due to being high-risk, these policyholders would have to pay higher premiums when applying for a policy. 

To reduce insurance premiums, some individuals may withhold information during the screening process such as family medical history and habits that may be considered detrimental to health like smoking. If this information is withheld, the policyholder may obtain coverage for a price that doesn’t match the level of risk the insurance company is taking on, which can lead to financial losses from the company.

To protect against adverse selection, insurance companies take may take measures to reduce their risk.

Adverse selection examples

To get a better understanding of what adverse selection is, consider the following examples:

  1. Not disclosing smoking habits and exercise history: Consider a scenario where two men of the same age and weight with no medical conditions apply for life insurance coverage. At a high-level, these individuals are similar and should have similar premiums. However, if one individual smokes often and rarely exercises while the other exercises four times a week — the individual who exercises more often should have lower premiums. If the person who smokes does not disclose this information and overstates how often they exercise to get a lower premium — the insurance company is taking on a larger risk than they realize. 
  2. Withholding a car accident that wasn’t reported to insurance: Outside of life insurance, consider a scenario where an individual is applying for car insurance with a new company. During the application process, the new insurance company will likely find any accidents that were reported to previous insurers. However, if the individual caused an accident that was not reported to their insurance company — there would be no record of this unless it is submitted by the policyholder during the application process. If the policyholder withholds an accident that was not submitted to insurance, they may receive a lower rate because on paper they have a better driving history. Furthermore, the original act of not reporting the accident to the previous insurer is also an example of adverse selection because it allowed the policyholder to continue coverage at a lower rate.

How adverse selection impacts the life insurance industry

Adverse selection poses a serious problem to insurance companies, and they may take several actions to mitigate their risk including:

  • A thorough application questionnaire
  • Requirements for a recent medical exam
  • Prescription history and medical records
  • Rate increases to account for unknown risk
  • Denying coverage for some individuals

During the underwriting process, insurance companies want to calculate an applicant’s level of risk as accurately as possible. However, the occurrence of adverse selection raises the level of risk for all applicants, which can lead to rate increases for everyone. Even if you’re a low-risk individual, your premiums may increase as a result of adverse selection. In some cases, this can lead to policies becoming unaffordable.

Furthermore, if it’s discovered that the applicant lied during the underwriting process — the insurance company may cancel coverage, adjust rates, or deny a payout. This will also be recorded on your Medical Information Bureau report, making it harder for you to get approved for another policy.

What to do if your insurance premiums become unaffordable because of adverse selection

If your life insurance rates have increased because of adverse selection and you no longer wish to continue coverage, you have three options:

  1. Lapse your life insurance policy: Lapsing your policy means you stop paying premiums, which ends coverage after the grace period. While this is an easy way to avoid high premiums, it also results in you getting nothing back which is why it’s not recommended.
  2. Surrender your life insurance policy: Rather than lapsing, you may be able to surrender your policy to the insurance company for a small cash sum. You won’t have to pay premiums and you’ll get some money back, but it’s not the best option if you want to maximize your return. 

Sell your life insurance policy: Instead of surrendering your policy to the insurance company, you may be able to sell it through a process known as a life settlement which can result in a payout 4 to 11 times more than the cash surrender value. The increased value comes from taking your policy to the free market, where you can get multiple offers instead of a single offer from the insurance company. If you’re interested in selling your policy, contact Harbor Life Settlements for a free policy estimate and see how much you can get.

Avery Logan

Avery Logan

Avery Logan is a writer for Harbor Life Settlements with expertise on insurance, finance, and senior care. He specializes in breaking down complex subjects in a way that's easy for people to understand so they can feel informed about what they're reading.

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