What is the concept of adverse selection in insurance?

The concept of adverse selection refers to the tendency of individuals who perceive themselves to be at higher risk to seek out insurance coverage more than those who see themselves as low risk. Therefore, individuals who are most in need of insurance—typically because they have a higher likelihood of filing a claim or suffering a loss—are the ones who are more likely to purchase insurance. This can create a situation where the insurance pool consists of a larger proportion of high-risk individuals.

Consequently, if insurers do not appropriately manage or price for this risk, they can end up paying out more in claims than they are collecting in premiums, leading to financial instability for the insurer. Understanding this concept is crucial for insurers to develop strategies that can mitigate the impacts of adverse selection, such as underwriting processes or setting premiums based on risk assessment.