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IAI Actuarial Core Principles · Business Economics · Pricing strategies in the financial services sector

A health insurer cannot observe which applicants are high-risk and charges every applicant the same premium based on the average expected claim. Over time, lower-risk people find the premium poor value and leave, raising the average claim cost of those who remain. Which term describes this process?

This is adverse selection. Because the insurer cannot distinguish risk types before contracting, a uniform premium drives out low-risk customers, leaving a costlier pool, which pushes the premium up further. Moral hazard is different because it concerns post-contract behaviour.

  1. AMoral hazard
  2. BAdverse selectionCorrect
  3. CCross-subsidisation by design
  4. DPrice discrimination of the first degree
  5. Economies of scope

Explanation

Adverse selection arises when hidden information before the contract causes high-risk individuals to be over-represented among buyers. Moral hazard concerns behaviour changing after cover is obtained, so it does not describe low-risk people leaving the pool.

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