What is 'adverse selection' in the context of insurance underwriting?

Adverse selection refers to a situation in insurance underwriting where individuals who are at higher risk of making a claim are more likely to seek insurance coverage compared to those who are at lower risk. This occurs because those who know they are more likely to face losses—such as individuals with pre-existing health conditions, risky professions, or lifestyle choices—tend to purchase insurance to protect against those potential losses.

This phenomenon can lead to an imbalance in the insurance pool, where the insurer might end up covering a disproportionate number of high-risk individuals. As a result, the overall cost of claims may be higher than expected, which can cause financial strain on the insurer and may necessitate higher premiums for all insured individuals.

Understanding adverse selection is crucial for insurers as they design and price their products, develop underwriting guidelines, and implement risk management strategies to balance their risk pool effectively. It highlights the importance of thorough underwriting processes to assess risk accurately and maintain the sustainability of insurance operations.