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

Adverse selection refers to the phenomenon where individuals who are at a higher risk of needing insurance coverage are more likely to seek out and purchase insurance policies. This occurs because those individuals are aware of their higher likelihood of experiencing a loss or claim, and they recognize that insurance can protect them against that risk.

In the insurance market, this can lead to a situation where an insurance company may find itself with a disproportionate number of high-risk policyholders. As more high-risk individuals buy insurance, the overall cost of claims for the insurer can increase, leading to higher premiums for all customers. Insurers must then carefully balance their pricing and underwriting practices to avoid the detrimental effects of adverse selection, which can undermine the sustainability of their business.

Recognizing this concept is crucial for understanding how insurance markets operate, as well as the strategies that insurers use to minimize its impact, such as thorough underwriting processes and risk assessment methods.