Suppose we take a group of insured individuals that actually consist of two groups: Smokers and non-smokers. Statistically speaking, among this combined group, non-smokers are likely to live longer than average, while smokers are likely to die younger than average. If the insurer sells life insurance policies to both non-smokers and smokers at the same premium rates, the smokers will not be paying premiums as long as the non-smokers (since their mortality rate is higher), but the smokers' beneficiaries will receive the same benefits. This would not be advantageous to the insurer. In this case, the insurer "selected" a group of individuals for coverage that "adversely" affects their profitability - "adverse selection." Insurers learn that they must compensate themselves financially for the anticipated earlier loss of the smoker group and therefore set a higher premium for that part of the group.

Back