What is the phenomenon of adverse selection in insurance?

The phenomenon of adverse selection in insurance occurs when there is an imbalance in information between the insurer and the insured. Specifically, it happens when individuals with a higher risk of filing a claim are more likely to purchase insurance than those who are at a lower risk.

When a high-risk person benefits more from insurance, they are often more motivated to seek coverage because they anticipate needing it due to their elevated risk profile. This leads to a situation where the insurer ends up with a disproportionately high number of high-risk policyholders, which can result in increased claims and losses for the insurer. The insurer, who may not fully understand the risk profiles of their clients at the point of sale, may set premiums based on average risks, which could ultimately lead to financial instability if too many high-risk individuals are enrolled.

In contrast, low-risk individuals may not feel the need to purchase insurance or may opt for lower levels of coverage, further skewing the risk pool. This dynamic can create challenges for insurance companies, necessitating strategies to mitigate adverse selection, such as thorough underwriting processes and risk assessment measures.