Which principle is key in underwriting to avoid unfavorable risk?

The principle of adverse selection is key in underwriting to avoid unfavorable risk because it relates to the asymmetry of information between the insurer and the insured. In situations where individuals with higher risks are more likely to seek insurance, insurers may ultimately find themselves with a disproportionate number of high-risk policyholders if they don't carefully manage their underwriting processes.

To mitigate adverse selection, insurers must thoroughly evaluate the risk profiles of potential policyholders, often using detailed questionnaires, medical exams, or credit history checks. By doing so, they can set premiums that reflect the actual risk presented by each applicant, thereby maintaining a balanced portfolio and protecting themselves against excessive claims.

The other principles, while important in risk management and insurance, play different roles. Risk pooling involves aggregating the risks of many individuals to reduce the variation in potential losses and create more predictable outcomes. Loss mitigation refers to strategies aimed at reducing the impact of insured losses. Insurance diversification is about spreading risk across multiple policies or lines of business to avoid significant losses from any single source. While these concepts are valuable, they do not directly address the challenges posed by adverse selection in the underwriting process.