What is "adverse selection" in the context of insurance?

Adverse selection refers to a situation in the insurance industry where individuals who are more likely to make a claim—typically those with higher risks—are more inclined to purchase insurance. This phenomenon can undermine the insurance pool because it can lead to an imbalance, where the insurer ends up with a higher proportion of high-risk policyholders compared to low-risk individuals.

As a result, insurers may face greater claims than anticipated, which can lead to increased costs for the insurer and potentially higher premiums for all policyholders. Understanding adverse selection is crucial for insurers as they design their products, assess risk, and set pricing to ensure they can remain profitable while still serving all segments of the market.

The other options do not capture the essence of adverse selection. Negotiating prices focuses more on the process of pricing strategies rather than risk evaluation. The relationship between competition and premiums looks at market dynamics instead of risk factors. Finally, the requirement for disclosure of previous claims pertains to underwriting and risk assessment but doesn't encapsulate the overarching issue of adverse selection. Hence, the correct choice is the one highlighting the tendency of higher-risk individuals to purchase insurance more often.