FRM Part I · FRM Exam Part I · Insurance Companies and Pension Plans
A health insurer charges a single premium based on the average risk of the population. Healthy individuals find the price too high and decline coverage, leaving a riskier pool and forcing the insurer to raise premiums further. Which statement best describes this process?
This is adverse selection leading to a premium spiral. With one average-risk price, healthy people exit, the remaining pool is riskier, and the insurer must raise premiums again. The problem comes from hidden information before the contract, unlike moral hazard, which concerns behavior after coverage starts.
- AAdverse selection that can lead to a premium spiralCorrect
- BMoral hazard that is controlled by deductibles
- CDiversification that lowers the insurer's loss ratio
- DReinsurance that transfers longevity exposure
Explanation
Because the insurer cannot distinguish risk types, low-risk people leave and the pool worsens, which pushes premiums higher. This is adverse selection, a pre-contract information asymmetry. Moral hazard concerns post-contract behavior, so it is wrong.
Did you get it right without looking?
One question tells you little. A timed set on Insurance Companies and Pension Plans shows your real accuracy, how long you take and where you lose marks.
More Insurance Companies and Pension Plans questions
- Which statement best describes who bears investment risk in a defined contribution (DC) pension plan compared with a defined benefit (DB) pl…
- A health insurer's policyholders who expect high medical costs are the most likely to buy generous coverage, while healthy individuals decli…
- An insurer has 10,000 identical one-year policies. Each has an independent 2% claim probability and a fixed claim amount of 50,000. What is …
- A defined benefit plan's liabilities are valued by discounting promised benefits at a high-quality corporate bond rate. Interest rates fall …
- A health insurer offers one standard premium to all applicants, set at the average expected claim cost of the whole population. Individuals …
- An insurer sells a 2-year term policy paying 100,000 at the end of the year of death. Annual mortality rates for the insured are q = 1% in y…