What does "adverse selection" mean in insurance?

Adverse selection refers to a situation in the insurance market where individuals who are at a higher risk of making a claim are more likely to seek insurance coverage than those who are considered low-risk. This occurs because higher-risk individuals are aware of their increased likelihood of encountering an insurable event, such as health problems, accidents, or property damage, and thus are more motivated to obtain insurance.

When insurers cannot distinguish between high-risk and low-risk applicants at the outset, they may end up with a pool of policyholders that primarily consists of those who are more likely to file claims. This can lead to higher overall costs for the insurer, as the claims will exceed what was anticipated based on the premium income, ultimately making it unsustainable for the insurance company.

In contrast, the other options highlight alternative concepts that do not accurately describe adverse selection. For example, the notion that low-risk individuals would be more likely to seek insurance contradicts the fundamental characteristic of adverse selection, while random selection does not address the risk-based motivations behind policyholder behavior. The underwriting process does involve risk evaluation but it is a separate procedure from the concept of adverse selection, which occurs prior to that evaluation when individuals are choosing to purchase insurance based on their perceived risk levels.