What does "adverse selection" refer to in the context of insurance?

Adverse selection in the context of insurance refers to the tendency for individuals who are at a higher risk of requiring insurance benefits to seek insurance coverage more than those who are at a lower risk. This phenomenon occurs when people who know they are more likely to use insurance are more motivated to purchase it, which can lead to an imbalance in the risk pool.

When higher-risk individuals predominantly purchase insurance, the insurer faces a higher likelihood of claims than anticipated, which can increase the overall costs for the insurance company. If not managed correctly, this can result in higher premiums for all policyholders and can even threaten the sustainability of the insurance model.

By understanding adverse selection, insurers implement measures such as underwriting processes to assess risks associated with potential policyholders and set appropriate premiums that correspond to their risk levels. This allows insurers to create a stronger balance in their risk pools by encouraging a mix of both higher and lower-risk individuals, leading to more stable financial outcomes for insurance providers.

In contrast, other concepts mentioned in the options highlight aspects of insurance practices such as underwriting, premium calculations, and the behavior of low-risk individuals with respect to insurance purchasing, which do not encapsulate the essence of adverse selection itself.