FRM Part I · FRM Exam Part I · Insurance Companies and Pension Plans
A health insurer charges one premium based on the average risk of the population. Healthier individuals find the premium too high and drop out, leaving a pool with higher average claims, which forces the insurer to raise premiums further. Which mechanism best describes this process, and which tool most directly addresses it?
It is adverse selection, where low-risk people exit and the pool worsens, causing a premium spiral. Underwriting questions and risk-based pricing address it by reducing the insurer's information disadvantage. Deductibles and limits mainly tackle moral hazard, not this pre-contract selection problem.
- AAdverse selection; underwriting questions or risk-based pricingCorrect
- BMoral hazard; introducing a deductible
- CMoral hazard; policy limits on payout
- DAdverse selection; increasing the insurer's reinsurance retention
Explanation
Pool deterioration as low-risk people leave is adverse selection, driven by hidden information held by the insured. Underwriting and risk-based pricing reduce the information gap. Deductibles and limits target moral hazard, a post-contract behavior issue.
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