What is the main reason behind adverse selection in insurance?

Adverse selection arises primarily because individuals who are at a higher risk of needing insurance tend to seek out coverage more than those who are at a lower risk. This inclination occurs because individuals are often aware of their personal health, lifestyle, and circumstances, which means those who have a higher probability of making a claim are more likely to purchase insurance. As a result, insurers may experience a disproportionate number of high-risk clients, which can lead to increased claims that may exceed the premiums collected from these individuals.

This situation creates a challenge for insurance companies because it can lead to higher costs, making it difficult to maintain profitability. If insurance companies cannot accurately predict risks and set premiums accordingly, they may be forced to increase rates across the board or restrict coverage options, potentially driving away low-risk clients who do not feel adequately compensated for their risk level. Understanding adverse selection is vital for insurers to create effective pricing strategies and maintain balanced risk pools.