What does adverse selection mean in insurance?

Adverse selection in insurance refers to the phenomenon where high-risk individuals are more likely to purchase insurance than low-risk individuals. This creates a situation where the insurer ends up with a disproportionate number of policyholders who are more likely to make claims, leading to higher costs for the insurer. This imbalance can result in increased premiums for all policyholders and can threaten the overall stability of the insurance pool.

When an insurance company does not have accurate risk information or fails to underwrite properly, it can inadvertently encourage adverse selection. Insurers often employ strategies such as medical underwriting or risk classification to mitigate this risk, aiming to ensure that a diverse range of individuals, encompassing both high and low risk, participates in the insurance pool. By doing so, insurers can maintain a more stable and financially sound operation.