When it comes to life insurance, insurance companies want to minimize risk by insuring healthy and low-risk policyholders, yet unhealthy and high-risk individuals are more likely to apply for coverage. This imbalance, a concept called adverse selection, means insurers are vulnerable to paying out numerous large claims, which could lead to unmanageable premium increases for existing policyholders or high rates of denied coverage among applicants that fall into certain categories.

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Typically, insurance companies charge high-risk policyholders more for their life insurance policies to compensate for the added risk. Some people are considered high-risk due to their health; others have thrill-seeking hobbies or inherently dangerous careers. While cutting out risky pursuits and making healthy choices may help keep your premiums lower, life insurance options are available to both high and low-risk individuals.

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What is adverse selection?

In life insurance, adverse selection describes the occurrence of individuals with a high-risk profession, hobby or health condition seeking 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.

Learn more: Guide to life insurance

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 are more likely to purchase life insurance than healthy, low-risk individuals, it puts a greater strain on life insurers’ ability to pay out death benefits for their policyholders. 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 joining 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 quite high premiums.

If an individual poses a greater risk to the insurance company than they disclosed on their application and are more likely to die 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. If this miscalculation occurs too frequently, insurance companies may deplete their reserves and have a harder time paying out claims.

Life insurance companies may miscalculate a policyholder’s risk if that person misstated information on their life insurance application. If the insurer discovers that an applicant completed their application fraudulently, 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.

Learn more: How much does life insurance cost?

Guaranteed insurability policy

If a high-risk applicant or a person with pre-existing health conditions wants permanent life insurance, but was denied coverage, they may want to apply for guaranteed issue life insurance. You don’t need to complete a medical exam to qualify for guaranteed issue life insurance, although you may need to complete a health questionnaire. Keep in mind that you likely won’t be able to purchase a guaranteed issue policy after the age of 80.

With most guaranteed life policies, if you die of natural causes within the first two years of the policy, you won’t receive the full death benefit. Instead, you’ll receive some portion of the premiums you paid. If you pass away after the two-year period, you will typically receive the full death benefit. These policies are typically significantly more expensive than other types of life insurance, but may be worth the cost if you’ve been denied coverage elsewhere.

How insurance companies collect information

If you’re in the process of buying life insurance, you may wonder what the underwriting process will look like. During the underwriting process, your insurer collects information in several ways before giving a life insurance quote. This serves as a check on each piece of information to ensure accuracy.

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 a history of mental health issues or tobacco use, it could be discovered later in the process — and could result in a denial of coverage or even a lawsuit. Since medical issues and pre-existing conditions can be discovered during the medical exam, disclosing everything you can upfront will help streamline the process.
  • Paramedical exam: Insurer may send a healthcare professional to your home or office to conduct an examination. Any inconsistencies in your application will be noted. For example, if you said that you were 20 pounds lighter on your application, the paramedical exam should catch it. If the medical exam presents difficulties for you due to a pre-existing condition or other issue, it may be possible to get no-exam life insurance, although these policies are typically much pricier than whole life insurance.
  • Doctor’s statement: If the underwriter has any questions about your health, they will ask your primary care physician for a statement. If the paramedical exam resulted in a suspicion that you’re a smoker in spite of you failing to disclose it on your application, the underwriter may question your doctor in detail about your smoking habits.
  • 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 would increase your risk of dying.
  • 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.

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.

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 life insurance company may be reluctant to pay out on death benefits if your death is caused by something related to a health concern you knew about, but didn’t disclose on your application.

If you are nervous about being denied coverage due to a pre-existing condition or other health issue, note that there are options available to you. Guaranteed issue life insurance, although expensive, does not require applicants to complete a medical exam.

Frequently asked questions

    • 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 a pre-existing condition on your initial application, it can deny your beneficiaries’ claim after your death. Even if the pre-existing condition had nothing to do with your death, the insurance provider could deny the claim, since the company may have increased your premiums or denied you coverage had it known about the pre-existing condition.
    • A graded death benefit is a feature of a guaranteed issue life insurance policy. Since it isn’t profitable for insurance companies to sell guaranteed issue life insurance to people who pass away immediately, these policies typically pay out a lower death benefit in the first few years of the policy. Usually, graded death benefits have a waiting period of two years. If the policyholder passes away before this waiting period ends, only a partial death benefit pays out. If the policyholder passes away after the waiting period, their full death benefit will pay out.
    • 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 have that concern if they have a substantial life insurance policy.