What is a primary effect of adverse selection in insurance?

Adverse selection occurs when there is an imbalance in the information available to different parties involved in an insurance transaction, particularly when potential insureds have more knowledge about their own risk levels than the insurer does. This typically results in higher-risk individuals being more likely to purchase insurance or seek more coverage than low-risk individuals. As a consequence, insurers, faced with a larger proportion of high-risk policyholders, must raise premiums to cover the anticipated losses from this increased risk.

When insurers adjust their pricing to account for the higher likelihood of claims from a pool dominated by higher-risk individuals, this can lead to a situation where all insureds face higher premiums, not just those who represent a higher risk. As the cost of premiums increases across the board, it can also drive lower-risk individuals out of the insurance market, which further exacerbates the problem of adverse selection. This cycle can lead to a less stable insurance market where the pool of insured individuals becomes less diverse and more prone to risk.

In summary, the primary effect of adverse selection is that it can lead to higher premiums for all insureds as insurers adjust their pricing structures in response to the altered risk profile of their policyholders.