What does adverse selection entail?

Adverse selection refers to a situation in insurance where those individuals who are at a higher risk for a loss or claim are more likely to seek out insurance coverage compared to those who are at a lower risk. This creates an imbalance where the insurer may end up with a pool of insured individuals that predominantly consists of higher-risk clients.

When high-risk individuals are more inclined to purchase insurance, it can lead to increased costs for the insurance company, as they may experience more claims than expected. As a result, this scenario can ultimately lead to higher premiums for all policyholders in order to balance the costs associated with the claims made by those higher-risk individuals.

This understanding highlights why adverse selection is a critical concept in insurance underwriting and pricing strategies. Insurers strive to mitigate adverse selection through various methods, such as implementing strict underwriting criteria or using premiums that reflect the actual risk levels of insured individuals.