California Life Agent Practice Exam – Practice Test & Study Guide

Adverse selection refers to a situation where an insurance company ends up insuring a disproportionate number of high-risk individuals compared to low-risk individuals. This occurs because those who perceive themselves as more likely to experience a loss are more inclined to purchase insurance. Consequently, the insurer faces a greater likelihood of having to pay out claims related to these risks.

When individuals who are more prone to loss seek insurance policies, the insurer encounters increased claims relative to the premium income generated from those policies. This phenomenon can lead to higher overall claim costs for the insurer, which can adversely impact their financial viability. Therefore, the definition of adverse selection is appropriately tied to the insuring of risks that are more likely to lead to losses.