What is adverse selection in insurance markets?

Adverse selection in insurance markets arises when individuals who expect to incur higher costs are more likely to purchase insurance, while those who expect to have lower costs are less inclined to do so. This phenomenon can lead to a disproportionate number of high-risk individuals within an insurance pool, which undermines the overall stability and profitability of the insurance plan.

When only those anticipating significant health expenses choose to buy insurance, it creates an imbalance. Insurers may find themselves covering a greater percentage of high-cost claims, which can necessitate higher premium rates. If the premiums become too high to accommodate less healthy individuals, it may further deter healthy individuals from enrolling in the insurance plan, worsening the cycle of risk selection.

In this context, the other options do not accurately portray the issue of adverse selection. Limiting premium rates to healthy individuals would not reflect the essence of adverse selection, nor would attracting low-risk individuals be a scenario that describes the adverse selection problem. Additionally, simply having limitations in insurance coverage options does not directly relate to the concept of individuals making decisions based on their expected health costs.