Adverse selection occurs when?

Adverse selection occurs when an insurer is unaware of the risk presented by an individual or group seeking insurance. This scenario creates a situation where individuals who are more likely to require insurance are more inclined to purchase it, while those who perceive themselves as lower risk may opt out. The insurer, lacking complete information about the risk level of applicants, may inadvertently cover those who pose a higher risk without charging appropriate premiums to reflect that level of risk. This can lead to financial losses for the insurer if not managed properly.

When an insurance company is unable to accurately assess an applicant's risk, it can result in a skewed pool of policyholders. This issue is compounded if the insurance provider bases its rates on broad averages that don’t adequately take into account the specific risks of individual clients. Understanding adverse selection is crucial for insurers as it emphasizes the need for effective underwriting practices and thorough assessments of applicants.