What is the result of adverse selection in insurance?

• A. The company has fewer claims than expected
• B. The company faces more loss than expected
• C. The company receives higher premiums
• D. The company improves its financial status

Answer: (B)

Adverse selection occurs when there is an imbalance of information between insurers and policyholders. Typically, individuals who are more likely to need insurance are also more likely to seek it out, while those who are at lower risk may choose to forgo coverage. This situation arises because individuals possess more knowledge about their own risk profiles than the insurance companies do.

As a result, when a higher proportion of high-risk individuals purchase insurance, the insurance company is faced with more losses than anticipated. The premiums collected may not accurately reflect the higher level of risk, leading to financial challenges for the insurer. These unexpected claims can greatly affect the company's profitability and sustainability because they may have set premiums based on an average risk pool that hasn't accounted for the adverse selection phenomenon. Hence, the statement that the company faces more loss than expected accurately describes the consequences of adverse selection.