What does 'adverse selection' refer to in the insurance field?

Adverse selection in the insurance context specifically refers to the phenomenon where individuals who perceive themselves as high-risk are more inclined to purchase insurance compared to those who consider themselves low-risk. This creates an imbalance in the risk pool, as insurers may end up with a higher proportion of policyholders who are more likely to file claims. Consequently, insurers could face significant financial challenges if they are not able to adequately price the insurance products to account for this risk.

When high-risk individuals seek coverage, they do so because they anticipate that their likelihood of experiencing a loss is higher than average. This often leads insurers to raise premiums, which can further exacerbate the problem as low-risk individuals might then opt out of purchasing insurance altogether, leaving the insurer with an even greater concentration of high-risk policyholders. Thus, adverse selection is critical for insurers to understand and manage, as it directly impacts their ability to sustain profitable operations.