What does adverse selection refer to in insurance?

Adverse selection occurs when there is an imbalance in the risks that individuals seeking insurance present to insurers. Specifically, it refers to the phenomenon where high-risk individuals are more likely to purchase insurance than low-risk individuals. This happens because those who perceive themselves as being at a greater risk of experiencing losses or needing to file claims are inclined to secure insurance coverage at standard rates.

As a result, insurers may end up with a pool of policyholders that has a higher overall risk than anticipated, leading to higher claims than expected and potential financial losses for the insurance company. This can create challenges in pricing and underwriting practices. Insurers strive to mitigate adverse selection by implementing measures such as underwriting guidelines, risk assessments, and premium adjustments that reflect the risk level of applicants more accurately.