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IAI Actuarial Core Principles · Economic Modelling · Role of insurance in reducing or removing risk

A health insurer charges one average premium to all applicants without being able to observe individual risk. Which sequence best describes the adverse selection spiral that may follow?

The spiral runs: a pooled premium rises, low-risk members leave, the remaining pool has higher average claims, and the premium must rise again. This repeats and can make the market shrink or collapse, because the insurer cannot observe individual risk.

  1. APremium rises, low-risk members leave, average claims per remaining member rise, premium rises againCorrect
  2. BPremium rises, high-risk members leave, average claims fall, premium falls
  3. CPremium falls, low-risk members join, average claims fall further
  4. DClaims fall because insured people take more care, so premium falls
  5. Premium stays fixed because pooling removes all risk differences

Explanation

With a single premium, low-risk people find it poor value and leave. The remaining pool is riskier, so average claims rise. The insurer must raise the premium again, driving out more good risks and repeating the cycle.

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