Final answer:
Underwriting is the process by which insurance companies classify potential clients into appropriate risk classifications to charge correct rates. It aims to ensure that individual risk is accounted for so the average payment covers claims, costs, and profits, preventing adverse selection.
Step-by-step explanation:
The process of classifying potential insureds into the appropriate risk classification in order to charge the appropriate rate is known as underwriting. Underwriting involves assessing each potential customer to determine the level of risk they pose to the insurer. Factors such as personal habits, genetics, area of residence, and past claims history may influence these decisions. For example, if an insurance company charges the actuarially fair premium to a group as a whole without considering individual risk factors such as family cancer histories, the company may end up with a pool of insured that is not balanced, leading to financial losses. This is because some individuals in the pool would pay less than the expected cost of their claims, while others would pay more, resulting in adverse selection. Charging different premiums for different risk groups ensures that the average payment covers claims, operating costs, and profits.