What is 'adverse selection' in the context of insurance?

Adverse selection refers to a scenario in the insurance industry where individuals who are at higher risk of making claims are more likely to purchase insurance than those who are at lower risk. This can occur because those high-risk individuals are aware of their increased likelihood of experiencing a loss, prompting them to seek coverage to protect themselves financially.

As a result of this imbalance, insurance companies may end up covering a disproportionate number of high-risk policyholders, which can lead to more claims than anticipated. This phenomenon can adversely affect the insurer's profitability and the overall sustainability of the insurance pool, as the premiums collected may not be sufficient to cover the claims made by these high-risk individuals.

Understanding adverse selection is crucial for insurers, as it influences their underwriting practices and pricing strategies. By implementing measures such as more thorough risk assessments or adjusting premium rates based on individual risk factors, insurers aim to mitigate the impact of adverse selection and maintain a balanced risk pool.