What does the term 'Adverse Selection' refer to in insurance?

The term 'Adverse Selection' refers specifically to the phenomenon where individuals who are at a higher risk of making a claim are more likely to seek out insurance coverage. This situation can arise because those individuals are more aware of their own health or risk factors than the insurers are, leading to a situation where the insurer ends up with a pool of policyholders that is riskier than the general population.

In practical terms, when adverse selection occurs, it can undermine the viability of insurance plans. If only higher-risk individuals buy insurance, it can lead to increased claims that exceed the premiums collected. This can result in the insurer having to raise premiums for all policyholders to cover the higher costs or, in some cases, lead to insurers exiting the market altogether.

The other options relate to different insurance concepts. The reduction of risk through diversification relates to a strategy where a company attempts to spread its risk across various sectors or lines of policyholders. The statistical calculation of future claims pertains to actuarial science, which estimates the likelihood and cost of future claims based on data analysis. The process of determining coverage limits involves setting the maximum amount an insurer will pay for covered losses, which is not directly related to the idea of who seeks coverage based on risk.