What does adverse selection in insurance refer to?

Adverse selection in insurance refers to a situation where individuals with a higher risk of needing insurance are more inclined to purchase it, while those at lower risk tend to opt-out. This characteristic of the insurance market can lead to an imbalance, where insurance providers end up with a larger proportion of high-risk policyholders. Consequently, this could result in increased claims and higher costs for the insurer, ultimately affecting pricing and availability of coverage for everyone.

This concept is fundamental in understanding the dynamics of insurance risk pools. When high-risk individuals are more likely to buy insurance, it creates a scenario where insurers may struggle to maintain profitability unless they adjust premiums to reflect the risk, which can further deter lower-risk individuals from purchasing coverage. Therefore, the correct answer focuses on the behavior of high-risk individuals in relation to insurance, encapsulating the essence of adverse selection.