Which situation is an example of adverse selection?

Adverse selection occurs when there is an imbalance of information between buyers and sellers, leading to the selection of high-risk individuals for insurance, while low-risk individuals may opt out. In this context, the situation where an applicant decides to buy commercial crime insurance after experiencing a burglary represents adverse selection because the individual is responding to a specific, heightened awareness of risk. After suffering a loss, the applicant now realizes the need for coverage and seeks insurance to mitigate further financial exposure.

This action demonstrates adverse selection because the buyer has inside knowledge of their increased risk due to the burglary, which the insurer may not be able to fully assess at the time of underwriting. As a result, the insurance company may find itself covering risks that are greater than what they typically forecast, potentially leading to greater losses.

The other scenarios do not illustrate adverse selection because they do not involve an individual who, based on specific risks, seeks coverage in a way that skews the overall risk assessment for the insurer. For example, choosing the least expensive auto policy or discussing coverage post-home improvements does not reflect a significant change in risk perception, and cancelling a policy suggests a belief in lower risk rather than an attempt to capitalize on undisclosed high risk.