How is adverse selection defined in the context of insurance?

Adverse selection in the context of insurance is defined as a situation where individuals who are at a higher risk of experiencing an insured event are more likely to purchase insurance than those who are at a lower risk. This imbalance occurs because high-risk individuals recognize their likelihood of needing coverage and are motivated to ensure they protect themselves financially, while low-risk individuals may feel less need to buy insurance or may opt for lower coverage. This can lead to a pool of insured individuals that is more risky than the general population, causing higher losses for the insurer and potentially leading to higher premiums or losses in the insurance market.

Understanding adverse selection is crucial for insurance companies as they strive to set premiums that adequately reflect risk and maintain the balance within their insured populations. The other options provided do not accurately encompass the phenomenon of adverse selection, as they either focus on aspects of pricing, fraud, or claims management without capturing the core concept of risk assessment among insured individuals.