What is the impact of adverse selection on an insurance company?

Adverse selection occurs when there is an imbalance in information between the insurer and the insured. Specifically, it happens when individuals who perceive themselves as higher risk are more likely to seek insurance coverage, while those who see themselves as lower risk are less inclined to do so. This behavior can lead to a situation where the insurance pool is composed mainly of high-risk individuals.

As a result of this skewed risk pool, the insurance company is likely to face higher claims than anticipated. To compensate for the increased risk of insuring this higher proportion of individuals with significant risks, the insurance company has to raise premium rates. By increasing premium rates, the insurer aims to cover the expected higher claims and to maintain their financial viability. This adjustment helps ensure that the company remains in a position to cover its liabilities but can also create a cycle that further drives low-risk individuals out of the market, exacerbating the issue of adverse selection.

The other options do not accurately reflect the typical outcomes associated with adverse selection. For instance, it does not lead to better risk management or reductions in overall claims; on the contrary, it heightens the risks faced by the insurer. Additionally, adverse selection does not foster competitive pricing, as higher premium rates are generally a response to increased risk