What is adverse selection in insurance?

Adverse selection refers to the phenomenon where individuals who perceive themselves to be at higher risk are more likely to seek insurance coverage, while those who view themselves as lower risk may opt out or underinsure. This imbalance can lead to a concentration of higher-risk policyholders within an insurance pool, which ultimately increases the likelihood of claims and financial losses for the insurer.

In insurance theory, this situation creates challenges for insurers as they might not be able to accurately set premiums that reflect the true risk of their overall policyholder base. As a result, insurance companies must find ways to mitigate adverse selection by employing strategies such as thorough underwriting processes, requiring medical exams, or using more comprehensive questionnaires to better assess risk levels among applicants. Understanding this concept is crucial as it highlights the importance of risk evaluation in maintaining a sustainable insurance model.