Why might insurance companies be concerned with adverse selection?

Insurance companies are concerned with adverse selection because it increases the likelihood that high-risk individuals will purchase insurance. Adverse selection occurs when there is an imbalance of information between buyers and sellers of insurance. Typically, those who have a greater risk of claims are more inclined to seek insurance coverage, while those who perceive themselves as low-risk may opt out of purchasing it altogether.

This phenomenon can lead to a scenario where the insurance pool is disproportionately filled with high-risk individuals, resulting in significantly higher costs for the insurer. If insurance providers cannot adequately price the premiums to reflect the greater risk associated with their insured population, it can jeopardize the financial stability of the company. Essentially, when only higher-risk individuals purchase insurance, it undermines the risk-sharing model that underpins the insurance industry, leading to potential losses and unsustainable premium rates.