What does "adverse selection" refer to in the context of insurance?

Adverse selection refers to a phenomenon where individuals who are at a higher risk for certain health issues are more likely to seek out insurance coverage. This creates an imbalance in the risk pool. When those who are more likely to need medical care—because of existing health problems or high-risk lifestyles—are the ones purchasing insurance, it can lead to a concentration of risk within the insurance pool. Consequently, insurers may face higher-than-expected claims, which can result in increased premiums or even financial instability for the insurer if not managed properly.

For example, if individuals who smoke, have chronic illnesses, or other risk factors are more inclined to buy health insurance, the overall costs for the insurer may rise due to these high-risk policyholders. If these individuals are not adequately balanced by a sufficient number of lower-risk individuals seeking coverage, it can lead to unsustainable insurance practices and financial losses. Thus, adverse selection presents significant challenges in maintaining a healthy insurance risk pool and is a critical concept in understanding how health insurance markets operate.