What impact does adverse selection have on insurance premiums?

Adverse selection occurs when individuals who are at higher risk for an insurance event are more likely to purchase insurance than those at lower risk. This phenomenon can significantly impact insurance premiums. When insurers are unaware of the risk levels associated with the individuals purchasing their policies, they may set a standard premium that does not accurately reflect the actual risk involved.

As a result, if a majority of policyholders are high-risk individuals, the insurer will likely experience a greater number of claims than anticipated. To cover these unexpected costs, the insurance company must raise premiums for all policyholders in future underwriting cycles to maintain financial stability. Consequently, the presence of adverse selection leads to increasing overall premiums, as insurers require higher rates to mitigate the risk associated with an influx of high-risk insured.

In contrast, lower premiums would occur if the risk levels were uniform and accurately predicted, and having no impact or eliminating risks does not align with the realities of how adverse selection influences insurance economics. Thus, the accurate answer reflects that adverse selection tends to increase insurance premiums.