What does 'adverse selection' refer to in insurance?

Adverse selection refers to the phenomenon in which individuals who are at a higher risk of making a claim are more likely to purchase insurance compared to those who are at a lower risk. This occurs because those with higher risks have a greater perceived need for insurance coverage. As a result, insurers may find themselves covering a disproportionately high number of policyholders who are likely to file claims. This can lead to increased costs for insurance companies, which may ultimately result in higher premiums for all policyholders as the insurer tries to balance the risk pool.

Understanding adverse selection is crucial for insurance companies as they develop their underwriting processes and pricing strategies. By accurately assessing risk, insurers can better predict the likelihood of claims, allowing them to set premiums that are both competitive and reflective of the actual risk involved.

The other choices do not correctly capture the concept of adverse selection. They suggest issues or aspects that are not directly related to the core idea of risk pooling and purchasing behavior based on individual risk levels.