What is the main concern of adverse selection in insurance?

Adverse selection in insurance occurs when there is a lack of asymmetric information between the insurer and potential clients, leading to a scenario where those who are at a higher risk are more likely to seek insurance coverage compared to those who are at lower risk. This situation is problematic for insurers because it can result in a pool of insured individuals that is riskier than what was anticipated or intended.

When insurers cannot correctly assess the risk levels of applicants, they may end up attracting a larger proportion of high-risk individuals. These individuals are more likely to file claims, which can lead to higher-than-expected payouts and ultimately jeopardize the insurer's financial stability. Thus, the primary concern surrounding adverse selection is that it can skew the risk pool towards higher risks, potentially causing detrimental financial consequences for the insurance company.

Addressing adverse selection typically involves strategies such as better underwriting practices, requiring completed health questionnaires, or implementing waiting periods for certain conditions, all of which aim to mitigate the risk of attracting a disproportionately high number of those who are more likely to incur claims.