What is meant by adverse selection in insurance?

Adverse selection in insurance refers to the phenomenon where individuals who are at a higher risk of making a claim are more likely to seek insurance coverage than those who are at lower risk. This can occur because high-risk individuals are aware of their likelihood of needing insurance benefits, leading them to pursue coverage more aggressively. As a result, insurers may end up with a pool of policyholders that is disproportionately composed of high-risk individuals, which can lead to increased claims and financial losses for the insurance company.

This concept is critical in the insurance industry because it affects how policies are underwritten and priced. Insurers strive to balance their risk pools to avoid the detrimental impact of adverse selection, which can lead to higher premiums for all policyholders if not managed properly. This is why insurers often implement measures such as medical underwriting, where applicants’ health status is evaluated before providing coverage, to mitigate the risk of adverse selection.