Explanation
Adverse selection is the correct answer because it specifically refers to the problem where insurance companies cannot distinguish between high-risk and low-risk individuals. In life insurance:
- Adverse selection occurs when individuals who know they are higher risk (e.g., have health issues, engage in risky behaviors) are more likely to purchase insurance than those who are lower risk
- This creates an imbalance in the risk pool, forcing insurers to charge higher premiums to cover the higher-than-expected claims
- Life insurance companies are particularly concerned about adverse selection because applicants have better information about their health and lifestyle than the insurer does
Why the other options are incorrect:
- B. Catastrophic risk: Refers to large-scale events affecting many policyholders simultaneously (e.g., natural disasters), not specifically about differentiating between individual risks
- C. Longevity risk: Concerns the risk that people live longer than expected, affecting annuity providers more than life insurers
- D. Moral hazard: Occurs after insurance is purchased, when insured individuals may engage in riskier behavior because they are protected, not about initial risk differentiation
Adverse selection is a classic information asymmetry problem in insurance markets where the inability to distinguish between good and bad risks leads to market inefficiencies.
