What is adverse selection in the context of insurance?

Adverse selection refers specifically to the phenomenon where individuals who are more likely to make claims (typically high-risk individuals) are more inclined to purchase insurance policies. This creates an imbalance because insurance companies may end up with a pool of policyholders that are at a greater risk of filing claims than the general population. This situation can lead to higher costs for insurers and ultimately may force them to increase premiums or restrict coverage.

In the context of insurance, adverse selection highlights the importance of underwriting practices that insurance companies utilize to assess the risk of potential policyholders. If an insurance provider cannot adequately identify and manage these risks, they may face significant financial challenges due to the high frequency and cost of claims from their insured demographic. Thus, understanding adverse selection is crucial for effective risk management and pricing strategies in the insurance market.