What is meant by "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 out insurance coverage. This situation arises because those with greater risk, such as those who have chronic health conditions or risky lifestyles, are more aware of their potential for loss and therefore are more inclined to purchase insurance. As a result, insurance companies may end up with a pool of insured individuals that is skewed toward higher risk, leading to potential losses.

This dynamic can force insurance companies to raise premiums to account for the increased risk in their policyholder base. If only high-risk individuals are purchasing insurance, the insurer must adjust their pricing structures to cover the predicted higher claims, which can create a cycle of increasing premiums and potential loss of lower-risk customers who may seek coverage elsewhere or decide it's not worth the expense.

The concept is critical in understanding the balance of risk in insurance models and highlights the importance of effective risk assessment and pricing strategies in maintaining an equitable insurance market.