What is adverse selection in insurance?

Adverse selection refers to a phenomenon where individuals who are at a higher risk of making a claim are more inclined to purchase insurance compared to those who are at a lower risk. This situation arises because those with greater knowledge of their own risk profile are more likely to seek coverage that reflects their heightened likelihood of incurring a loss. As a result, if an insurance provider does not have mechanisms to appropriately assess risk, they may end up with a disproportionate number of high-risk policyholders. This can lead to financial losses for the insurer since the likelihood of claims exceeds the premiums collected.

In contrast, the other options do not accurately capture the essence of adverse selection. For instance, the notion that low-risk individuals are more likely to buy insurance contradicts the concept; low-risk individuals typically perceive less need for coverage, as they anticipate lower chances of experiencing a loss. Misleading clients does not relate to the fundamental issue of risk selection and is more about unethical practices within the industry. Lastly, the idea of a method to improve insurance coverage options does not align with the concept of adverse selection, which primarily addresses the imbalance created by risk assessment rather than enhancing policy offerings.