Adverse Selection Life Insurance: How It Impacts Your Policy
For an insurance company to accurately determine the risk of insuring an applicant, they must collect as much information as possible – including health history, occupation, and lifestyle habits. If buyers fail to disclose this information to sellers, adverse selection occurs.
Contrary to popular belief, withholding information in an attempt to secure a cheaper life insurance policy puts you at a disadvantage. In this guide, you'll learn how adverse selection impacts health insurance coverage and what insurance companies are doing to combat it.
What Is Adverse Selection?
Adverse selection refers to one party withholding critical information from another. Professionals also refer to this as asymmetric information or information failure.
Both buyers and sellers are affected by adverse selection, as they can’t make informed decisions. For example, a buyer might not disclose their high-risk occupation as a stunt man or racecar driver. Another example might occur if a smoker chooses not to disclose their habit. This puts the insurer at risk of making poor assessments and losing money.
When an insurance company is exposed to risk because of adverse selection, that’s called a moral hazard.
How Adverse Selection Affects Insurance
An insurance company prices insurance premiums according to an individual's risk factors such as age, gender, health, and occupation. Naturally, higher-risk buyers will pay higher premiums. If people hide a health condition or other essential information, an agent may charge less for insurance coverage because they did not know about the risk.
The more people take advantage of adverse selection, the higher the risk of financial loss for the insurance company. As such, some companies will increase insurance rates or limit coverage to account for unknown risks.
Aside from higher premiums and reduced coverage, there are other consequences of being dishonest on your application. This includes:
Your insurer can legally decide not to distribute claims to your beneficiaries.
You can be charged with a misdemeanor or a felony.
So, why do people lie? Mostly because insurance can get prohibitively expensive for high-risk individuals, and a majority of Americans without a policy think they can’t afford it.
How Insurance Companies Protect Against Adverse Selection
Insurers have many safeguards to combat adverse selection – the underwriting process is one of them. Here’s how companies pinpoint potentially fraudulent applications.
During the initial insurance application, a person must disclose basic information such as their age, health, and job. While some people think they can get away with omitting information on their application, a health insurance firm may discover this fraud later on. If they do, they may reject your application.
Your agent may cross-verify your application with other insurers you may have applied to, like your vehicle manufacturer (for car insurance) or bank.
Medical Exam & History
Because of how medical underwriting affects premiums, most individuals prefer policies without health exams. In fact, this is a key reason insurance sales have dropped to 50%, compared to 63% of individuals with life insurance in 2010.
If you buy a traditional policy for more coverage, your seller will send a healthcare professional to your home or office to complete a medical exam. If you leave any information out of your application, the examiner will catch it during the physical. Even if they don't, they may learn about your health status after contacting your primary care physician and reviewing your prescriptions.
Motor Vehicle Records
An insurance company may also request your driving record, which includes any previous violations, from the DMV. Again, anything you choose not to disclose with a seller may still be on your DMV record.
How Insurance Companies Address Adverse Selection
The insurance industry deals with its fair share of fraud and the occasional moral hazard. To combat adverse selection, companies have to be more robust with their applicant screening process.
Many health insurance entities require customers to fill out a highly detailed insurance questionnaire. Through this questionnaire, insurers can accurately price an insurance policy and prevent loss.
Health insurance companies must also accurately verify details disclosed by customers. They do this by contacting your primary care physician, employer, or other insurance agents. Finally, firms may place caps on coverage to minimize financial damage.
Unfortunately, when it comes to life insurance, the adverse selection remains rampant. When in doubt, just remember that honesty is the best policy.
An insurance company likely has the resources to investigate inconsistencies and identify fraudulent applications. If you are caught in a lie, you run the risk of losing your coverage entirely.
If you want to learn more about adverse selection and the policy application process, check out the helpful resources on this website. We publish valuable content about the best insurance practices and how you can secure the policy that best suits your needs.