What is adverse selection in insurance?

Adverse selection occurs when individuals who are at a higher risk of requiring insurance coverage are more likely to purchase insurance, while those who are at a lower risk may choose not to buy it. This leads to a disproportionate number of high-risk individuals within the insurance pool, which can result in higher overall claims costs for the insurer.

In the context of the choices provided, the selection of unhealthy or high-risk applicants accurately describes this phenomenon. It highlights how these individuals, aware of their poor health or risk factors, opt for coverage, ultimately skewing the risk profile of the insured group. Insurers may face challenges in setting premium rates that are sustainable in the long run since they may receive more claims than expected from this segment of the population.

The other options do not encapsulate the essence of adverse selection accurately. For instance, healthy applicants opting for lower premiums doesn't relate directly to the core concept of adverse selection. Similarly, denying coverage to high-risk applicants falls under underwriting practices aimed to mitigate adverse selection but isn't itself a description of adverse selection. Lastly, adjusting premium rates is a reactive measure to deal with adverse selection rather than a definition of the issue itself.