What does ‘adverse selection’ refer to in insurance?

Adverse selection refers to a situation in the insurance market where individuals with a higher risk of making a claim are more inclined to buy insurance coverage compared to those who are at a lower risk. This phenomenon can lead to an insurance pool that is disproportionately filled with higher-risk individuals, which in turn increases the likelihood of claims being filed.

When higher-risk individuals are more likely to purchase insurance, insurance companies may face potential losses because the premiums collected may not sufficiently cover the payouts made for claims. This imbalance can strain the insurer’s resources and complicate their ability to maintain sustainable operations. The ideal scenario for insurers is to have a balanced mix of both high and low-risk individuals, as this spreads risk and helps keep premiums at reasonable levels.

In contrast, situations where lower-risk individuals purchase more coverage or where there is a reduction in coverage for risky behaviors do not encapsulate the concept of adverse selection. Understanding this dynamic is crucial for both insurers and consumers as it influences underwriting processes, premium pricing, and overall risk management strategies in the insurance industry.