What is the meaning of adverse selection in insurance?

Adverse selection in insurance refers to a situation where individuals who believe they have a higher probability of a claim or loss are more likely to purchase insurance compared to those who see themselves as low risk. This phenomenon occurs because individuals possess more information about their personal risk levels than insurers do. As a result, those who know they have a higher risk of needing insurance—such as individuals with pre-existing health conditions or dangerous occupations—are more inclined to secure coverage. This can lead to a situation where the insurer's risk pool is disproportionately filled with high-risk individuals, potentially resulting in greater costs for the insurer.

This understanding of adverse selection is crucial in the insurance industry, as it highlights the importance of accurate risk assessment and pricing models to ensure that insurance products remain viable and fair for all policyholders. The adverse selection problem can lead insurers to increase premiums for all policyholders or to impose stricter underwriting guidelines, which may ultimately reduce access to insurance for those who are genuinely low risk.