What is one of the primary risks associated with adverse selection?

Adverse selection occurs when an insurer attracts a higher proportion of individuals who are at greater risk of filing claims, often because these individuals are more aware of their own risk levels than the insurer. One of the primary risks associated with this is that the insurer becomes exposed to higher claim costs.

When an insurance company has a clientele that includes many high-risk individuals, it can lead to a situation where the total claims paid out significantly exceed the premiums collected from those individuals. This imbalance can threaten the insurer's financial stability and profitability, as they may not have adequately priced their policies to cover the anticipated risk of claims. In essence, adverse selection can undermine the risk-pooling mechanism fundamental to the insurance model, resulting in increased claim expenses that the insurer needs to manage.

Understanding this risk is crucial for insurers; they often implement strategies such as underwriting processes and risk assessments to mitigate the impacts of adverse selection by attempting to ensure a more balanced distribution of risk among their policyholders.