What is "adverse selection" in insurance?

Adverse selection refers to a scenario in the insurance industry where individuals who are more likely to file claims—typically those with higher perceived risk—are more inclined to purchase insurance coverage. This phenomenon can lead to an imbalance in the insurance pool, as insurers may end up with a higher proportion of high-risk individuals compared to low-risk ones.

When only those who anticipate needing benefits opt for insurance, the insurer faces potential losses since the premiums collected may not adequately cover the higher claims from these individuals. Consequently, this can impact the overall sustainability of the insurance system. Insurers often implement various strategies, such as underwriting guidelines and risk assessments, to mitigate adverse selection and attract a balanced mix of policyholders. Thus, the definition of adverse selection is essential for understanding how risk is managed in the insurance market and how it influences pricing and availability of insurance products.