What is the primary challenge of adverse selection in the insurance market?

Adverse selection in the insurance market primarily refers to the difficulty that insurers face in distinguishing between high-risk and low-risk individuals. When insurance companies are unable to effectively identify which customers are more likely to require coverage, they risk attracting a higher proportion of individuals who are more likely to file claims—those who perceive a greater likelihood of needing insurance due to their health status or behaviors.

This phenomenon leads to a scenario where healthier individuals may opt not to purchase insurance because they believe the premiums do not match their risk level, leaving the insurer with a pool of predominantly higher-risk individuals. As a result, the costs to the insurer increase, which may lead to higher premium rates for everyone, and potentially could drive healthy individuals out of the market altogether. Thus, the primary challenge of adverse selection is indeed identifying the healthier individuals, as doing so would allow insurance companies to keep overall costs lower and maintain a balanced risk pool.