What does the term "adverse selection" indicate in insurance?

The term "adverse selection" refers specifically to the phenomenon where high-risk individuals are more inclined to obtain insurance compared to those at lower risk. This occurs because high-risk individuals are more likely to perceive greater value in insurance as they foresee a higher chance of needing to utilize it. As a result, if insurers do not adequately adjust their pricing or risk assessment, they may find themselves with a disproportionate number of high-risk policyholders. This can lead to increased claims and financial instability for the insurance company.

Understanding adverse selection is crucial for insurance providers, as it highlights the importance of accurately assessing risk and pricing policies accordingly to maintain a balanced and sustainable portfolio of insured individuals.