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

A health insurer in India cannot observe which applicants are in poor health, while applicants know their own condition. It sets one premium based on the average expected claim of the whole population. Which outcome is most likely?

Adverse selection is most likely. A pooled premium overcharges healthy applicants, who leave, so the remaining pool is riskier and the insurer must raise the premium, which can spiral. Moral hazard is different because it concerns changed behaviour after cover is bought.

  1. AHealthy applicants find the premium too high and leave, so the pool worsens and the premium must rise (adverse selection)Correct
  2. BInsured people take less care after buying cover, which is moral hazard arising before the contract is signed
  3. CHealthy applicants subsidise nobody because the premium equals each person's own expected claim
  4. DEvery applicant buys cover because a pooled premium is always below their own expected cost
  5. The insurer's average claim cost falls because only low-risk people remain

Explanation

With a single pooled premium, low-risk people pay more than their expected cost and tend to drop out. The remaining pool is riskier, so average claims and the premium rise. This is adverse selection, which occurs before contracting; moral hazard concerns behaviour after cover begins.

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