What is adverse selection?


In insurance, adverse selection is when an insurance company rates someone as lower risk than they actually are because that person withheld information during the application process.

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When you apply for life insurance, you’ll answer many questions about your health and lifestyle and may undergo a medical exam during underwriting. Underwriting helps insurers set their rates and protects them from something called adverse selection.

For life insurers, adverse selection happens if you conceal details that would earn you a less favorable rate, like a smoking habit. Here’s how adverse selection applies to life insurance and how it can impact your policy and your beneficiaries.

Key Takeaways

  • Adverse selection is when one person in a contract or negotiation has information that the others don’t.

  • In insurance, it occurs when a high-risk person pays less for coverage than they should.

  • Insurance providers try to prevent this with strict underwriting guidelines.

  • Being dishonest on your application could result in your family being denied a payout when you die.

What is adverse selection in life insurance?

Adverse selection occurs when one of the parties in a contract or negotiation knows information that the others don’t, giving them an advantage. In an insurance context, it applies when you leave out information that would have put you in a higher risk category—and earned you higher premiums—had your insurer known.

This could be a person applying for health insurance who conceals a family history of chronic illness or someone applying for car insurance who doesn’t disclose previous accidents.

Examples of adverse selection in life insurance

Life insurance underwriting measures your provider’s risk by how likely you are to die while your policy is active. Adverse selection in life insurance involves people who would receive higher premiums based on medical history or lifestyle risks like:

Failing to disclose any of the above would cause an underwriter to believe you’re less of an insurance risk than you really are. 

If you leave out or misstate details by mistake, don’t worry. In most cases, this information is discovered during the underwriting process and you can make corrections.

How adverse selection impacts life insurance companies

Insurance companies need to be able to accurately predict your risk so they can reliably pay out insurance claims to all of their customers. 

Based on the company’s calculations, the premiums paid over the life of your policy should be able to fund your death benefit. A higher-risk person who hides details from their insurer might die sooner than predicted while paying lower premiums than they should have been, leaving a gap between what they’ve paid and the death benefit the insurer owes. 

If the insurer has to fill that gap from their cash reserves, then it loses money. The financial losses caused by too much adverse selection would eventually jeopardize the insurance company’s ability to pay out even legitimate claims.

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How adverse selection affects your life insurance policy

In the worst case, too many instances of adverse selection lead to increased life insurance rates for all of an insurer’s customers. But insurance providers already have processes in place to protect against adverse selection, so you’re unlikely to feel a personal impact.

The effect is clearest during underwriting, when you’ll be asked extensively about your lifestyle and health and the underwriter will conduct a thorough review of records including:

  • Attending Physician Statement (APS) from your doctor

  • Financial information

  • Medical Information Bureau (MIB) reports of your previous insurance applications

  • Motor vehicle report 

  • Prescription history 

What happens if you’re dishonest when buying life insurance?

If you contribute to adverse selection by withholding information from your insurer, then you won’t just cause issues for the insurance company, but yourself as well. Intentionally concealing or misrepresenting details on your application is fraud, and your insurer can cancel your policy or deny your application.

If your application is declined because you lied, it’ll go on your MIB report and can make it harder for you to be approved for another policy. If you manage to be approved and a lie is discovered later, your provider can deny or reduce the payout to your loved ones.

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Adverse selection causes issues for insurance companies that can get passed on to customers. Be totally honest when applying for a life insurance policy, otherwise you’ll contribute to rising rates and jeopardize your family’s financial protection.

Frequently asked questions

What does adverse selection mean?

Adverse selection is when one party in a negotiation or contract has more information than the others.

How does adverse selection apply to life insurance?

An insurer might offer lower rates than they should to an applicant who conceals a diagnosis or habit that makes them riskier to insure, like smoking.

Why does adverse selection matter for life insurance shoppers?

Too much adverse selection might lead to higher insurance rates. If you try to hide information from your insurer, your loved ones could be denied a payout when you die.