What is the potential negative outcome when policy owners take advantage of favorable options in insurance contracts?

Adverse selection occurs when individuals with a higher risk of loss are more likely to seek out insurance coverage than those who are at lower risk. This can lead to an unbalanced risk pool, as those who are healthier or less likely to make claims may choose not to purchase insurance, leaving the insurer with a disproportionate number of high-risk policyholders.

When policy owners take advantage of favorable options in insurance contracts—such as comprehensive coverage or low premiums—they may have a higher likelihood of needing to make claims compared to individuals who do not select these options. This behavior can exacerbate the problem of adverse selection, as insurers may struggle to maintain profitability and sustainability of their coverage offerings.

In essence, adverse selection highlights the challenges insurers face in pricing policies appropriately based on the risk profiles of their clients and underscores the importance of using sound underwriting practices to mitigate these risks.