How can adverse selection affect insurance underwriting?

Adverse selection is a phenomenon that occurs when there is an imbalance in the information available to buyers and sellers in the insurance market. Specifically, it often refers to situations where individuals who are at a higher risk of making a claim are more likely to purchase insurance, while those who are at a lower risk are less inclined to do so.

When high-risk individuals secure insurance, they are more likely to maintain their policies because they have a stronger financial incentive to do so. This creates a scenario where the insurer takes on a disproportionate number of high-risk clients. As a result, the insurer may face increased claims, leading to higher overall risk for the company. To counter this imbalance, insurers may subsequently raise premiums or tighten underwriting criteria, which can further discourage low-risk individuals from obtaining coverage.

In this context, the correct answer illustrates how adverse selection results in high-risk individuals being more likely to seek and maintain insurance. This dynamic poses a challenge for insurers, who must navigate the complexities of risk management and pricing while ultimately aiming to protect themselves from the negative impacts of adverse selection on their overall portfolio.