What Is an Adverse Selection?

What Is an Adverse Selection?

By Charles Joseph | Editor, Financial Affairs
Reviewed by Corey Michael | Senior Financial Analyst

Adverse selection is a concept in economics that refers to a situation where sellers have information that buyers do not have, or vice versa, about some aspect of product quality. Essentially, it is a scenario of imperfect information, which can lead to an imbalance in transactional outcomes that can negatively impact the market. For instance, it can occur in insurance markets, where those with a higher risk are more likely to purchase insurance, creating a pool of risk that’s not reflective of the larger population.

Related Questions

1. How does adverse selection affect insurance firms?

Adverse selection can have a significant impact on insurance firms. If a large number of high-risk individuals buy insurance, the firms have to pay out a lot more in claims. This can eventually cause the insurance premium to increase, discouraging low-risk individuals from buying the policy, leading to a disproportionate number of high-risk policyholders.

2. Can adverse selection be eliminated?

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Eliminating adverse selection is not entirely possible due to the nature of markets and information asymmetry. However, it can be managed. Measures such as thorough risk assessment, proper pricing strategies, and risk differentiation can help control the impact of adverse selection on businesses.

3. How is adverse selection related to moral hazard?

Adverse selection and moral hazard are both concepts related to asymmetric information. Adverse selection happens before a transaction, where one party has more information than the other. On the other hand, moral hazard occurs after the transaction, where one party might change their behavior in a way that’s harmful to the other because they are protected from risk.

4. What is an example of adverse selection?

An example of adverse selection is the insurance market, as mentioned above. People with high-risk lifestyles are more likely to purchase life insurance than those with low-risk lifestyles. This is because high-risk individuals know that the likelihood of their needing the insurance payout is greater than what the insurers estimate, leading to a disproportionately high number of risk-prone policyholders.

5. What is the result of adverse selection in the long run?

In the long run, adverse selection can lead to market failure. This is because high-quality goods and low-risk clients are squeezed out of the market due to overall higher prices. It can also reduce trust in the market and discourage trade and transactions, inevitably harming the economy.