This paper attempts to explain why individuals may purchase whole life insurance even when term (short period) insurance seems to be less expensive. Under a whole life insurance contract (referred to also as straight life insurance) the insured pays the same rates over his or her lifetime although his or her future health may change. Individuals whose health has deteriorated (relative to their age) over time are more likely to hold on to their contracts than individuals whose health has improved (relative to their age) and who may find it profitable to break their contract and purchase a new one. The insurer, recognizing this adverse selection problem, must set its price for the initial period (and thus for the entire life of the insured) so that it compensates for the above-mentioned adverse selection. The insurer will hence set the price (rate) of whole life insurance higher than the rate of term insurance, since the latter form of insurance is not susceptible to future adverse selection. Assuming the competition between insurers drives their profits to zero (i.e., assuming they provide fair premiums), it is shown that the equilibrium price of whole life insurance is higher than for term insurance. The insured, however, will purchase only whole life insurance, since the additional insurance which the whole life contract provides on the stochastic future insurance rates is priced fairly, and a rational risk-averse insured will always prefer purchasing such insurance.
International Adverse Selection in Life Insurance and Annuities