1.1 The insurer will calculate the premium for a term or whole life insurance policy assuming that the policyholder is in relatively good health; otherwise, if the insurer assumed that all purchasers were unhealthy, the cost of insurance would be prohibitive to those customers who are healthy. The assumption then is that claims will be relatively rare in the first few years of insurance, especially since most policies are sold to lives in their 30s and 40s.

This means that the price is too low for a life who is very unwell, for whom the risk of a claim shortly after purchase might be 10 or 100 times greater than for a healthy life. The insurer therefore needs evidence that the purchaser is in good health, to avoid the risk that insurance is bought too cheaply by lives who have a much higher probability of claim.

The objective of underwriting is to produce a relatively homogeneous insured population when policies are issued. The risk that the policyholder purchases the insurance because they are aware that their individual risk is greater than that of the insured population used to calculate the premium, is an example of adverse selection risk. Underwriting is a way of reducing the impact of adverse selection for life insurance.

Adverse selection for an annuity purchaser works in the other direction – a life might buy an annuity if they considered their mortality was lighter than the general population.