What does adverse selection refer to?

Adverse selection refers to the phenomenon where individuals with a higher risk of experiencing loss are more likely to seek insurance coverage. This trend can create an imbalance in the insurance pool, as insurers may end up covering a disproportionate number of high-risk individuals without adequately accounting for the increased likelihood of claims.

When high-risk individuals, such as those with preexisting health conditions or hazardous occupations, apply for insurance more frequently than low-risk individuals, it can lead to increased costs for the insurer. This can ultimately affect premium rates, as insurers may need to raise prices to cover the higher anticipated payouts from claims made by those high-risk policyholders.

In this context, recognizing adverse selection is critical for insurers to implement strategies such as underwriting processes that help assess risk levels accurately, manage their risk exposure, and ensure that premiums reflect the risk within a well-balanced insurance pool.