What is 'adverse selection' in insurance?

Adverse selection is the tendency for people with higher-than-average risk to seek insurance more eagerly than people with lower-than-average risk, while the insurer has incomplete information about individual risks. Left unmanaged, adverse selection makes pricing unsustainable — the insurer collects premiums calibrated for average risks but pays claims weighted toward high-risk insureds. Insurers control adverse selection through underwriting (gathering information to classify risks accurately), differential pricing (higher premiums for higher risks), exclusions (e.g., suicide clauses, contestability period), and policy design features. The simpler the underwriting (guaranteed issue, no medical questions), the higher the premiums must be to offset adverse selection. Understanding adverse selection is foundational to insurance theory.