In life insurance, what does the term "adverse selection" refer to?

Adverse selection refers to the phenomenon in which individuals who are at higher risk for claims are more likely to seek out insurance coverage. This situation creates an imbalance in the insurance pool, as the insurer ends up with a higher proportion of high-risk policyholders than expected.

When people who are aware of their own higher risk (due to health conditions, lifestyle choices, or other factors) choose to purchase insurance, this can lead to increased costs for the insurer. If an insurance company cannot effectively assess the risks associated with applicants or set appropriate premiums, they may face significant financial challenges due to the higher likelihood of payouts.

Understanding adverse selection is crucial for insurers as they design their products and pricing strategies, attempt to manage risk, and maintain profitability in their operations. Hence, recognizing that those with higher risk are more inclined to buy insurance helps in addressing potential imbalances in risk pools.