What does "adverse selection" signify in the context of insurance?

In the context of insurance, "adverse selection" refers to the tendency of higher-risk individuals to seek insurance coverage, which can lead to an imbalance in the risk pool. When individuals who are more likely to file a claim—such as those with pre-existing health conditions or higher likelihood of accidents—are more prone to purchase insurance, it can have significant implications for the insurer.

This phenomenon results in a situation where the insurer may end up covering a disproportionately high number of risky policyholders compared to those who are lower-risk. As a consequence, insurance companies may face greater overall claims than anticipated, which can lead to higher premiums for all insured parties to compensate for the increased risk. Understanding adverse selection is crucial for insurers in assessing risk and setting rates fairly, thus maintaining the sustainability of insurance products.