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FRM Part I · FRM Exam Part I · Insurance Companies and Pension Plans

A health insurer offers one standard premium to all applicants, set at the average expected claim cost of the whole population. Individuals who know they are in poor health buy coverage at a much higher rate than healthy individuals. Which outcome is the most likely consequence if the insurer takes no corrective action?

The pool becomes riskier than priced. Because high-risk people buy coverage more readily, actual claims exceed premiums set on the population average. Premium increases then push out healthier buyers, further worsening the mix, a spiral caused by adverse selection.

  1. AThe pool becomes riskier than assumed, claims exceed premiums, and premiums must be raised, driving out more healthy buyersCorrect
  2. BThe insurer's claims fall below expectations because the healthy buyers subsidize the unhealthy
  3. CPolicyholders reduce their preventive care after purchase, which is the only source of loss
  4. DThe insurer's risk is fully diversified because the pool grows larger

Explanation

This is adverse selection: applicants with private information about higher risk buy more insurance. The average claim cost of the actual pool exceeds that of the population, so a premium based on the population average is too low. Raising premiums causes healthier people to leave, worsening the pool (a death spiral). Option C describes moral hazard, not the described issue.

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