When does adverse selection occur in insurance?

Adverse selection occurs when the individuals seeking insurance are not equally representative of the population and, specifically, when those who are more likely to experience risks are the ones purchasing the insurance. In this context, when it is stated that a risk insured is more likely to experience losses than average, it highlights the essence of adverse selection.

This phenomenon often arises because insurance providers cannot perfectly assess the risk associated with an individual compared to the broader population. As a result, individuals at higher risk are more inclined to seek insurance, leading to a pool of policyholders that are riskier than the average. This can result in higher overall claims for the insurer than anticipated, which can threaten the financial stability of the insurance model as premiums would need to increase to cover these unexpected losses.

In contrast, the other scenarios involve different aspects of risk and insurance dynamics but do not encapsulate the concept of adverse selection in the same way. For instance, underreporting of risks could lead to inaccurate assessments but does not inherently reflect the self-selection behavior characteristic of adverse selection. Similarly, high premiums or frequent policy renewals, while relevant to insurance practices, do not necessarily denote that the insured risks are skewed towards higher losses.