What do insurers typically do to mitigate the risks associated with adverse selection?

Insurers typically use the strategy of rejecting high-risk applicants to mitigate the risks associated with adverse selection. Adverse selection occurs when individuals who are at a higher risk of making a claim are more likely to seek insurance compared to those who are at a lower risk. By carefully assessing the risk level of potential policyholders through underwriting practices, insurers can identify those who pose a greater risk and choose to reject their applications. This helps to keep the overall risk pool balanced and minimizes potential losses associated with insuring higher-risk individuals who are more likely to file claims.

Offering insurance to everyone could lead to significant financial losses for insurers, as they would have to cover many high-risk individuals without adequately pricing their risk. Providing lower premiums for high-risk individuals would also be counterproductive, as it invites more adverse selection, further increasing the likelihood of claims. Encouraging more claims is contrary to an insurer's goal, as it leads to greater financial exposure and undermines the fundamental purpose of insurance, which is to provide protection against unforeseen losses. Hence, rejecting high-risk applicants is a crucial measure that insurers take to maintain a sustainable and profitable business model amidst the challenges of adverse selection.