Define the term adverse selection and its impact on insurance markets.

• A. Adverse selection occurs when higher-risk individuals are more likely to buy insurance, raising premiums and potentially destabilizing markets.
• B. Adverse selection occurs when too many people buy insurance.
• C. Adverse selection occurs when insurers incorrectly pay claims.
• D. Adverse selection occurs when premiums are too low.

Answer: (B)

Adverse selection happens when buyers have more information about their own risk than the insurer. People with higher expected medical costs are more inclined to buy or renew coverage, while healthier individuals may opt out. This shifts the insured pool toward higher risk, causing insurers to raise premiums to cover expected losses. As premiums rise, even more low-risk people drop out, pushing the pool’s average risk up further and potentially destabilizing the market.

It’s not about having too many people buying, nor about insurers paying claims incorrectly, nor about premiums simply being too low. The core idea is how risk composition in the insured pool, driven by information asymmetry, drives pricing and market stability.