What challenge does “adverse selection” present to insurers?

Adverse selection is a critical concept in insurance that refers to a situation where individuals with a higher risk of filing a claim are more likely to seek insurance coverage than those with a lower risk. This phenomenon can create significant challenges for insurers. When high-risk individuals disproportionately obtain insurance, it leads to an imbalance in the risk pool. As a result, insurers may face higher-than-expected losses, as they end up covering more claims than they initially calculated.

In a typical risk-sharing model, insurers rely on a diverse group of policyholders, including both low-risk and high-risk individuals, to balance the overall risk. However, when the pool skews toward individuals who are more likely to experience a loss, insurance companies can suffer financially, leading to increased premiums for everyone or even the potential for some companies to exit certain markets altogether. Thus, understanding and managing adverse selection is vital for insurers to maintain profitability and sustainability in their offerings.