What does "adverse selection" mean in the context of health insurance?

In the context of health insurance, "adverse selection" refers to a situation where individuals with higher health risks are more likely to purchase insurance compared to those who are healthier. This occurs because people who anticipate needing more medical care—due to pre-existing conditions or other health issues—are motivated to obtain insurance to mitigate their potential financial burden from healthcare costs.

As a result, if a health insurance pool consists primarily of individuals with higher health risks, the insurer may face significant losses, leading to increased premiums for all policyholders. Adverse selection can distort the insurance market because it can prevent insurers from accurately pricing risk, potentially leading to market instability or even failure if healthier individuals choose to forego insurance altogether.

This situation illustrates the importance of mechanisms like risk pooling and policy designs that incentivize healthy individuals to participate in the insurance market, which helps balance the costs incurred by insurers.