What is meant by the term "adverse selection" in insurance?

The term "adverse selection" in insurance refers to a situation where consumers who are at higher risk are more likely to seek insurance coverage than those who are at lower risk. In this context, when consumers buy insurance knowing they have a higher risk of making a claim, it typically leads insurers to charge lower premiums, which may not adequately reflect the actual risk involved. This imbalance can result in a situation where the insurer has a higher proportion of policyholders who are likely to file claims, ultimately leading to financial losses for the insurer. By accurately recognizing adverse selection, insurers can better manage their risk and adjust their premium pricing strategies accordingly to mitigate the impact of higher-risk individuals disproportionately entering the insurance pool.