What is referred to as adverse selection in insurance?

Adverse selection refers to a situation in the insurance industry where an insurer ends up insuring a higher proportion of individuals who are at greater risk of making a claim than the general population. This occurs because individuals who perceive themselves as having a higher likelihood of needing insurance are more likely to seek it out. Consequently, insurers may face a higher claims rate than they anticipated, which can lead to financial difficulties if not managed properly.

When an insurer is unable to distinguish between high-risk and low-risk applicants effectively, it may inadvertently insure a pool that is more prone to losses than the average. This can impact the pricing of insurance policies and the overall profitability of the insurance company, as higher risks necessitate higher premiums to remain financially viable.

Understanding adverse selection helps insurance professionals develop strategies to mitigate its impact, such as implementing stringent underwriting criteria or using risk classification methods to ensure that premiums align more closely with the risk that the insurer is taking on. This concept is fundamental in insurance as it influences underwriting practices, premium setting, and overall risk management in the industry.