What is adverse selection in insurance?

Adverse selection refers to the phenomenon where individuals who are considered to be higher risk are more likely to purchase insurance compared to those who pose a lower risk. This occurs because those who anticipate needing insurance coverage are more inclined to seek it out, leading to a disproportionate number of high-risk individuals in the insurer's risk pool.

This creates challenges for insurance companies, as they may collect premiums from a higher percentage of high-risk insureds, potentially leading to greater claims costs than anticipated. To mitigate adverse selection, insurers often use underwriting processes to evaluate the risk associated with insuring a particular individual or entity and to set premiums accordingly. Understanding adverse selection is crucial for maintaining the stability and financial viability of an insurance company.