What does "adverse selection" mean in insurance?

Adverse selection refers to a situation in insurance where individuals who perceive themselves to be at a higher risk are more likely to seek insurance coverage compared to healthier individuals who do not feel the need for it. This can lead to an imbalance in the risk pool, as the insurance provider ends up insuring a larger proportion of higher-risk individuals.

When an insurer does not adequately manage adverse selection, they may face financial difficulties because they are required to pay out more in claims than they receive in premiums. This phenomenon underscores the importance of risk assessment and premium adjustment strategies to maintain a balanced risk pool.

In contrast, the other choices do not accurately capture the concept of adverse selection. Lowering premiums annually does not relate to the risk perception of insured individuals. Rejection of high-risk applicants pertains to underwriting practices rather than the dynamics of risk selection. The time period for disputing claims relates to claims processing rather than the behavioral economics influencing insurance participation.