What does "adverse selection" mean in the insurance context?

• A. When low-risk individuals opt for insurance
• B. When individuals with higher risk buy insurance more frequently
• C. When insurance becomes too expensive
• D. When policies are renewed excessively

Answer: (B)

In the context of insurance, "adverse selection" refers to a situation where 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 discrepancy can lead to an imbalance in the risk pool. When primarily high-risk individuals buy insurance, it increases the likelihood of claims being made, ultimately impacting the insurer’s ability to manage the risk effectively.

As the insurance company faces more claims than expected, they may have to increase premiums to cover the losses, which can further exacerbate the issue. This self-perpetuating cycle makes it challenging for insurers to maintain balanced premiums and sustainable business models, as they rely on a mix of low and high-risk policyholders to spread out risk and keep costs manageable. Hence, the selection of high-risk individuals leads to adverse outcomes for insurance providers.