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

Adverse selection in the context of insurance refers to the phenomenon where individuals who are at greater-than-average risk are more likely to seek out and purchase insurance coverage. This happens because people with higher risk profiles—such as those with pre-existing health conditions or risky occupations—are more aware of their risks and are inclined to protect themselves against potential financial losses.

When a higher proportion of high-risk individuals buy insurance, it can lead to an imbalance within the insurance pool, where the risk burden is unevenly distributed. Insurers may not be able to correctly price their premiums if they are unaware of the risk levels of their insureds, leading to financial losses for the company. As a result, understanding adverse selection is crucial for insurers to assess risks accurately, set appropriate premiums, and maintain the financial stability of their policies.

Other answer choices do not capture the essence of adverse selection as they either misrepresent the behavior of insured individuals or deal with unrelated aspects of insurance pricing and statistical analysis, rather than the core concept of risk selection among potential insured parties.