What is meant by adverse selection in insurance?

Adverse selection refers to the phenomenon where individuals who are more likely to require insurance coverage are the ones most inclined to seek it. In other words, it indicates a higher probability of risk among those who apply for insurance. This tends to occur because individuals who perceive themselves as poor risks, typically due to pre-existing health issues or other risk factors, are more motivated to obtain insurance than those considered to be healthier.

In this context, when poorer risks apply for and obtain insurance, it raises the overall risk profile of the insurer's pool of policyholders. Consequently, this can lead to increased claims and financial losses for insurance companies if not mitigated through proper underwriting and rate-setting practices. Insurers must therefore manage adverse selection carefully to maintain sustainability and profitability.

The other options depict scenarios that do not grasp the essence of adverse selection. Healthier individuals typically do not contribute to adverse selection; instead, they are less likely to seek coverage, which can create an imbalance. Similarly, while insurers strive to predict future claims accurately and regulate premiums based on various levels of risk, these processes are aspects of risk management rather than defining adverse selection itself.