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Adverse selection occurs when there is an imbalance in the insurance risk pool, particularly when high-risk individuals are more likely to purchase insurance than low-risk individuals. In essence, adverse selection occurs because those who anticipate facing higher risks are more inclined to seek insurance coverage. This is problematic for insurers because if only those at greater risk are buying insurance, it can lead to financial instability for the insurer. By predominantly attracting high-risk individuals, insurance companies may find themselves with a disproportionate amount of claims, which can result in higher premiums and potentially unprofitable operations.

In contrast to adverse selection, when low-risk individuals are more inclined to purchase insurance, it could actually benefit the insurer by diversifying the risk pool. Lower premiums than the market average may indicate that the insurer is underpricing the risk or trying to capture a larger market share, but it does not inherently lead to adverse selection. Claims being filed more frequently than expected can be a result of adverse selection but are not a definition of the term itself. Thus, identifying adverse selection involves focusing specifically on the behavior of high-risk individuals in the insurance marketplace.