What does "adverse selection" refer to in the insurance industry?

Adverse selection in the insurance industry refers to the phenomenon where individuals who are at a higher risk of experiencing a loss are more likely to seek insurance coverage compared to those at lower risk. This can create a scenario where the insurer ends up with a pool of policyholders that is skewed towards higher-risk individuals, leading to increased costs for the insurance company.

When insurers are unable to accurately assess and price the risk associated with potential policyholders, they may face unsustainable loss ratios. This can result in higher premiums for all policyholders, as the insurer must account for the increased likelihood of claims made by those more likely to experience a loss. Managing adverse selection is crucial for insurers as it affects their profitability and viability in the market.

Other options do not accurately depict the concept. For instance, stating that insurers support higher-risk individuals exclusively overlooks the critical balance they must maintain to ensure profitability. Similarly, selecting policyholders based on health history does not encapsulate the broader issue of risk assessment associated with the overall population. Lastly, the idea that low-risk individuals are encouraged to take on insurance directly counteracts the essence of adverse selection, which is predicated on the concentration of higher-risk individuals within the insurance pool.