What does "adverse selection" in insurance mean?

Adverse selection is a phenomenon that occurs when individuals with a higher likelihood of filing a claim are more inclined to seek insurance coverage. This situation arises because those who perceive themselves as high-risk are more motivated to purchase insurance, while individuals who are low-risk may opt not to buy it or may only seek limited coverage.

When insurers face a pool of applicants that includes a disproportionate number of high-risk individuals, they encounter increased overall risk. This imbalance can lead to higher claim rates than anticipated, ultimately resulting in financial challenges for the insurance provider. Insurers must address adverse selection through underwriting practices, risk assessment, and pricing strategies to maintain a balanced risk pool and ensure profitability.

The other options do not accurately reflect the concept of adverse selection. For instance, saying that insurers are eager to cover low-risk individuals misses the essence of adverse selection, as it focuses on the motivation of the insurer rather than the behaviors of higher-risk clients. Similarly, careful selection of clients and a low risk of loss both misrepresent the ramifications and nature of adverse selection in the insurance market.