What is adverse selection in the context of insurance?

Adverse selection occurs when there is an imbalance of information between buyers and insurers, leading to undesirable outcomes for the insurance company. In the realm of insurance, adverse selection specifically refers to a situation where individuals with a higher likelihood of making a claim are more inclined to purchase insurance than those at lower risk. This typically arises because the insurer does not have complete information about the risk profiles of its applicants.

When consumers possess more information about their health, habits, or other risk factors than the insurer, they may select insurance policies that do not accurately reflect their risk. As a result, the insurer might underestimate its exposure to claims, leading to higher losses than anticipated. This phenomenon leaves the insurance company vulnerable, as it might attract a disproportionate number of high-risk policyholders. To counteract adverse selection, insurers often implement measures such as careful underwriting, risk assessment, and possibly higher premiums for higher-risk individuals, but these can be limited by the initial asymmetry of information.

In this context, while the other options touch on various aspects of insurance practices and decisions, they do not encapsulate the essence of adverse selection as it relates to information asymmetry leading to higher-risk individuals seeking insurance coverage disproportionately. Thus, the second option captures the true meaning of adverse selection