Adverse selection in life insurance

Life insurance is all about risk management. The thing is, most people think buying life insurance is black and white. You want protection, you buy a policy. But insurers know it’s far more complicated. Some individuals are more likely to seek coverage precisely because they understand their vulnerabilities — maybe it’s that family history of heart disease, holding a high-risk career or having a passion for skydiving.

These higher-risk individuals naturally gravitate toward life insurance, creating a market challenge that most people rarely see. It’s not about playing the system; it’s about seeking financial protection when you know you might need it more than others. This phenomenon is what insurance experts call adverse selection — those with risk factors tend to seek out life insurance more than those who are healthy. This concept impacts how life insurance works, how premiums are calculated and ultimately, how companies stay financially stable in an unpredictable world.

What is adverse selection?

In life insurance, adverse selection describes the occurrence of individuals with a high-risk profession, hobby or health condition applying for life insurance more often than low-risk individuals. Since it is likely that these policies will be paid out sooner and more often than average or low-risk policies, insurance companies have to find a way to balance profitability and affordability.

Charging higher premiums to people who fall into the high-risk category allows insurance companies to have enough money to meet their financial obligations at the time of a claim. It also gives them the ability to offer affordable rates to individuals who are more likely to pay into the policy over a longer period of time.

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How adverse selection impacts the life insurance industry

Life insurance providers attempt to accurately profile each policyholder’s risk class so that the company is prepared to pay out death benefits when needed. Each of your premium payments will fund your death benefit when you pass away. When unhealthy or high-risk individuals purchase life insurance more often than healthy, low-risk individuals, it puts a greater strain on life insurers’ finances. Because of this, life carriers may be more likely to increase premiums or outright deny coverage to higher-risk applicants.

Life insurance underwriters group policyholders into the following risk classes:

• Preferred: Preferred class policyholders are in great health, but could have a few minor issues. Thanks to their good health, individuals in this class will likely have relatively low premiums.
• Standard: Standard policyholders have average health and life expectancy. Many policyholders in this class have a history of family health issues that prevent them from qualifying for the preferred class.
• Substandard: Substandard policyholders are higher risk than average. They may have high-risk hobbies or lifestyles or even a chronic health issue. Different insurers handle this class differently, but policyholders in this class will typically have increased premiums.

If an individual poses a greater risk to the insurance company than they disclosed on their application and the life insurance company is more likely to have to pay out the claim before the date that the insurance company determined, there will be a gap between the amount the policyholder paid in premiums and their death benefit. The insurance company will have to cover this difference with its financial reserves. It’s imperative for insurers to balance their revenue and expenses to maintain financial soundness.

Life insurance companies may miscalculate a policyholder’s risk if that person misstates information on their life insurance application. If the insurer discovers that an applicant made material misrepresentations, it may deny payment to the policyholder’s beneficiaries. In general, the possibility of adverse selection may lead insurers to charge higher premiums to higher-risk individuals or even deny them coverage.

However, if a risky applicant is denied coverage, they can always apply for a guaranteed issue life insurance policy, designed for those who don’t want to undergo a medical exam or answer questions about their health and lifestyle.

Guaranteed insurability policy

If you’ve been denied traditional life insurance (term life, whole life, etc.), guaranteed issue may be an option — no health questionnaires, no medical exams, just straightforward coverage for those who need it most. These policies have carved out a niche in the insurance market, particularly for individuals aged 50 to 80 who might find themselves facing health challenges or other risk factors that typically make coverage hard to find.

However, guaranteed issue policies come with a price. You’ll likely notice higher premiums paired with more modest death benefits compared to traditional policies, which is a result of skipping the usual underwriting process. Perhaps the most important detail to understand is the graded death benefit clause, a safeguard that many insurance companies have adopted. During the first two years, natural causes of death won’t trigger the full death benefit. Instead, your beneficiaries would receive a refund of premiums paid. Accidental deaths, however, may be eligible for a full death benefit during this waiting period. After this two-year waiting period, the full death benefit protection kicks in.

Despite these limitations, guaranteed issue insurance fills a gap in the market. For those who’ve faced rejection elsewhere, these policies offer accessibility when it matters most. While not the most cost-effective option, they serve as a valuable tool for those who might otherwise have no alternatives for providing funds to loved ones for end-of-life expenses.

How life insurance companies collect information

You can think of the initial life insurance quote as a first handshake — an introduction, but just the beginning. While basic factors like age and sex can give you a rough sketch of costs, the real premium emerges after underwriting is complete. This is where insurers roll up their sleeves and dig into the details of your health and lifestyle, turning your initial estimate into a rate that fits your unique risk profile, kind of like getting measured for a custom suit rather than buying off the rack.

The insurer may collect information through:

• The initial application: You’ll be asked to provide basic information about yourself, your health, your job and hobbies. Although you may be tempted to leave something off the application, such as tobacco use or prescription history, it could be discovered later in the process — and could result in a denial of coverage or your beneficiaries being denied a claim. Since medical issues and pre-existing conditions can be discovered during the underwriting process, disclosing everything you can upfront will help streamline the process.
• Paramedical exam: A healthcare professional will meet you where it’s convenient (home or office) to conduct their medical exam. If there are any surprises between what you reported and what they find, additional questions or requirements could be requested during underwriting. Here’s the good news, though: The insurance world is evolving. Many companies now offer no-exam policies that can match traditional rates, assuming you check the right boxes for health and lifestyle.
• Doctor’s statement: Don’t be alarmed if your insurer requests a statement from your doctor, even if your application seems straightforward. It’s a routine step to verify the information you provided and ensure they fully understand your health profile. They might seek clarification on pre-existing conditions, medications or general health trends. This thorough process supports accurate underwriting and helps determine appropriate premiums.
• Prescription list: The underwriter can also access information on what prescription drugs you currently take or have taken in the recent past. This may shed light on chronic illness or past disease that may increase the risk the insurer takes on.
• Medical Information Bureau (MIB) listing: This organization exchanges confidential coded data about medical conditions and risk factors to alert insurers of potential omissions or errors in applicants’ reported medical histories. The MIB uses a system of proprietary codes rather than providing specific medical details in order to protect individuals’ privacy. If past application information doesn’t line up with your life insurance application, your insurer could become suspicious. Any alerts from the MIB may prompt further investigation by the insurer but cannot alone justify an adverse underwriting decision. Additionally, an MIB report will not show whether an applicant was denied or approved.

All of this information helps present the underwriter with a fuller picture of who you are and what sort of risk you would pose to the life insurance company. The application is only the first of several ways that the company gathers information on you.

If, after all this, an untruth slips through the process, this is called misrepresentation. If misrepresentation is discovered and your life insurance company can prove you intentionally lied, you could be charged with life insurance fraud.

It’s important to know that the first two years of the majority of life insurance policies also include a contestability period. During this time, insurers have the right to investigate claims, making sure there were no key details left out on the application. If any inaccuracies are noticed, the insurer might deny the claim, reduce the death benefit or even cancel the policy. Once this period ends, your coverage becomes more ironclad. The moral of the story? Honesty is the best policy when applying for life insurance.

Life insurance companies actively work to offset adverse selection. This ensures they remain financially stable and apply fair premiums to all policyholders.

Frequently asked questions

• What is the contestability period?

  A contestability period is a predetermined amount of time — usually two years — in which a life insurance company can investigate your application for omissions or mistakes. If your life insurance company finds out that you failed to disclose something on your application that directly impacts your approval or the rate you pay, they may adjust your premium or policy’s death benefit, deny your beneficiaries’ claim after your death or cancel your policy.

  Insurers can only assess factors related to you before and at the time your policy becomes effective. In other words, if you receive a medical diagnosis post-approval and after the policy is placed in force, you won’t be negatively impacted. The contestability period specifically pertains to disclosed information and diagnoses up to the policy’s activation.

• What is the graded death benefit?

  If you’ve been exploring guaranteed issue life insurance, you might have stumbled upon the term “graded death benefit.” In a nutshell, it’s a feature that includes a waiting period, usually two years, during which the full death benefit isn’t available for non-accidental deaths.

  So, if the policyholder passes away due to an accident within this period, their beneficiaries will receive the full death benefit. However, if the death is caused by something else, such as a heart attack or stroke, the beneficiaries typically get a refund of the premiums paid but no death benefit.

  Once the waiting period is over, the full death benefit kicks in, whether death is caused by an accident or natural causes. This structure allows insurers to manage risk while still offering coverage to people who might be considered higher risk.

• What is a moral hazard in life insurance?

  Essentially, a moral hazard is an insurance and financial concept about how having insurance can impact behavior. People may take on more risk than they usually would if they seemingly have a safety net in place. While it may seem morbid, this principle applies with regard to life insurance. For example, an individual who is the sole provider for their family may shy away from risky actions since they know the financial impact the loss of their income would have. However, people in similar economic circumstances may not be as opposed to taking more risks if they have a substantial life insurance policy and know their family is financially protected.