Why is adverse selection considered a risk for insurers?

Adverse selection is a phenomenon in insurance markets where individuals with a higher risk of filing a claim are more likely to purchase insurance compared to those at lower risk. This situation creates a skewed risk pool because the insurance company ends up insuring a larger proportion of high-risk policyholders. When high-risk individuals dominate the pool, the insurer faces a greater likelihood of paying out claims, which can lead to financial instability and higher costs for the insurer.

The presence of adverse selection can also lead to higher premiums for all policyholders, as insurers attempt to cover the increased risk. As more high-risk individuals join, they inflate the costs of claims, causing further imbalance in the risk pool. This cycle can ultimately drive away low-risk customers, who may find the premiums too high relative to their risk, leading to a less diverse pool of insured individuals and increasing the potential for losses for the insurer.

In essence, the crux of adverse selection lies in its ability to skew the demographic of an insured group towards those more likely to file claims, which is why this option best represents the core issue faced by insurers regarding risk management.