What is "adverse selection" in insurance?

Adverse selection in insurance refers to a situation where one party possesses more information about a risk than the other party, typically leading to a disproportionate amount of high-risk individuals seeking insurance coverage compared to low-risk individuals. This imbalance occurs because the insured, having more knowledge about their own health, lifestyle, or potential risk factors, may be more likely to purchase insurance or seek out policies that provide extensive coverage.

When insurers cannot accurately assess the level of risk associated with potential clients due to this asymmetry of information, they may inadvertently set premiums too low. This can lead to a higher concentration of higher-risk policyholders, resulting in greater claims than anticipated and potential financial losses for the insurer. Thus, understanding adverse selection is critical for insurers as they develop pricing strategies and risk assessment models.

The other options do not capture the essence of adverse selection. Balancing insured and uninsured risks refers to a different aspect of risk management. Sharing equal risk is not applicable to adverse selection, as that concept focuses on unequal information rather than risk sharing. Updating policies generally pertains to the revisions made to existing contracts and does not relate to the critical issue of information asymmetry inherent in adverse selection.