Adverse Selection in Life Insurance

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4 min read
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Adverse selection is a financial term that means one party in a transaction has information that the other party doesn’t have. For example, if you sell a car knowing the starter is faulty and neglect to disclose this information, the principle of adverse selection means you may get more money for the car than it’s worth.

What does adverse selection insurance mean for the life insurance industry? According to insurance expert Laura Adams, “when it comes to life insurance, ‘adverse selection’ is industry jargon that means an insurer believes a policyholder is less risky than they really are.”

What is adverse selection?

Adverse selection can be a problem for insurers who sell life, auto, health and other types of insurance.

Insurance companies determine your premium rate by looking at all the variables present in your application. The more likely it is that you’ll make a claim on your policy, the higher your premium.
With life insurance, even a small lie on your application can be considered adverse selection. “For instance,” says Adams, “if you apply for a life insurance policy but don’t disclose that you’re a smoker, you may be charged a lower, non-smoking rate.” Because smokers are more at risk of illness than the general population, you’re receiving a lower rate than you would have gotten if you’d been honest on your application.

It may seem like a small thing, but giving incorrect information or leaving out important details, when you are purchasing a policy is never a good idea. “If the insurer discovers that you completed your application fraudulently, they may have the legal right to deny payment to your beneficiaries,” Adams says.

Lying on your application may also cause the company to deny coverage if the lie is discovered. If you’re a smoker, for example, even if you neglect to mention it on your application, the company may find out the truth when they receive your physician’s statement later in the underwriting process. That lie is likely to make them wonder if insuring you is a good idea.

“Always be honest with your life insurance company and make sure that your loved ones will be protected financially after your death,” Adams says.

How adverse selection impacts the life insurance industry

Adverse selection life insurance may lead to insurers charging less for policies than they might otherwise. Your policy cost is determined by algorithms the underwriters access to determine the likelihood of your death while the policy is in force. If that risk is low, so is your premium.

But because of adverse selection, the industry has to account for the fact that some people will commit fraud or omit information from their applications that will result in low premiums but a higher risk of death. That means the company has to pay out on more claims.

To account for this, insurers pass that cost on to you, the policyholder, charging a little more for premiums to counter the increased claims they have to pay on accounts with undetected adverse selection. So, even if you are honest on your application, you may be paying for those who aren’t.

How insurance companies collect information

During the underwriting process, your insurer collects information in several ways, which serve as a check on each other to ensure accuracy. Those ways may include:

  • The initial application: You’ll be asked basic information on yourself, your health, your job and hobbies. Although you may get away with leaving something off the application, it could be discovered later in the process — and result in a denial of coverage.
  • Paramedical exam: The insurer sends a healthcare professional to your home or office to conduct an examination. Any inconsistencies in your application will be noted. For example, if you shaved twenty pounds off your weight on your app, the paramedical exam should catch it.
  • Doctor’s statement: If the underwriter has any questions about your health, they will ask your primary care physician for a statement. If, say, the paramedical exam resulted in a suspicion that you’re a smoker when you said you weren’t, the underwriter may question your doctor in detail about your smoking habits.
  • Prescription list: The underwriter can also access information on what drugs you currently take or have taken in the recent past. This may shed light on chronic illness or past disease that would increase your risk of dying.
  • Medical Information Bureau listing: This industry organization collects info that you’ve submitted on past applications for life, health, auto or other insurance. If it doesn’t line up with what you’ve said on the current application, it will raise suspicions.
  • Motor vehicle report: The underwriter will also pull a report on your driving activities from your state’s DMV. If you haven’t honestly recorded the fact that you are a high-risk driver or have serious violations on your record, it may work against you because it will be clear from the data the DMV collects on you.

All of this information presents the underwriter with a full picture of who you are and what sort of risk you would be to the insurer. 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. You may congratulate yourself on getting away with it, but don’t be so sure you have. If this information comes to light later on and the insurer can prove it was an intentional lie, you’ve committed fraud.

Some life insurance policies have a two year period, called the contestable period, during which the policy can be canceled if misrepresentation comes to light. Even if the lie is caught after this period, your insurer may be reluctant to pay out on death benefits if your death is caused by something that you knew about but didn’t disclose in your application.

The bottom line

In the end, honesty is the best policy when applying for life insurance. Insurers have trained staff who are skilled at sniffing out lies and inconsistencies, and some even work with investigators to prove fraud after the fact. All your premium payments may come to nothing if a lie on your application results in denial of payment or reduced payment on your death.