What does ‘adverse selection’ mean in the context of insurance?

In the context of insurance, ‘adverse selection’ refers to the phenomenon where individuals who are at higher risk for making claims are more likely to seek insurance coverage than those who are at lower risk. This situation arises because those who perceive themselves to be at greater risk (due to health issues, dangerous occupations, or other factors) are motivated to purchase insurance to protect themselves from potential financial losses. As a result, insurers are faced with a higher proportion of policyholders who are likely to file claims, which can lead to higher overall claims costs for the insurance company.

This dynamic can create a challenging environment for insurers, as it can result in imbalance within the risk pool. Insurers rely on a mix of low, moderate, and high-risk individuals to maintain profitability; if only high-risk individuals are buying coverage, it can lead to increased premiums for all insureds or even threaten the viability of the insurance model itself. Thus, understanding adverse selection is critical for the pricing of insurance products and managing risk within an insurance portfolio.