Adverse Selection

What Is Adverse Selection?

Adverse selection is a phenomenon in market economics in which buyers have information that sellers do not have or vice versa. In most situations, people act as if they have perfect knowledge about all aspects of the marketplace. In fact, they often don’t; they have snippets of information that are often inaccurate, incomplete, or weird. 

Market investors exploit this fact by systematically purchasing expensive inventory using deceptive practices, waiting to purchase carefully selected products once prices have fallen, and so on.

Symmetric information occurs when buyer and seller have the same or very similar information.

Adverse selection is an economic term used in the insurance market. The tendency of individuals most likely to file a claim to buy insurance has resulted in increased premiums and reduced coverage for most customers.

Understanding Adverse Selection

Adverse selection occurs when one party in a transaction has relevant information the other lacks. Information asymmetry leads to decisions that are biased towards potentially less profitable or risky segments.

Adverse selection is a situation in insurance or economics where the insured pool is riskier on average than the general population. This results in more claims being paid out by insurance companies to cover losses. Most insurers use underwriting guidelines to evaluate applications for coverage. These guidelines address current health, medical history, family history, occupation, hobbies, driving record, and lifestyle risks such as smoking.

When an insurance application is submitted to the company, it will assess the risk of accepting them against the cost of not having that customer. Then based on that assessment, they will decide whether to grant them a policy or not.

Adverse Selection in the Marketplace

Adverse selection is the name given to the phenomena whereby sellers of goods may have better information about offering products and services, putting buyers at a disadvantage. This happens where there is asymmetric information, which means one party to the transaction has more or better information than another about an offering. Adverse selection is a market failure in transactions where the seller has better information than the buyer.

For example, a stockbroker specializing in penny stocks may hide any knowledge he has about the overinflated stock price. The buyer may be easily swayed by positive presentation and information unless they are educated enough to make an educated decision.

In the absence of perfect information, buyers have to pay a premium to acquire companies with undervalued shares. In a second-hand transaction, a buyer is in a disadvantageous position when a seller knows the true problems behind the product but does not disclose them.

Adverse Selection in Insurance

Adverse selection means that people who expect to face higher health costs are more willing to pay higher premiums. Because of this, insurers find that they lose money on insurance if they charge average rates for ordinary people. 

Adverse selection occurs when the price charged to a particular group of customers changes based on individual characteristics, thus making it easier for a company to identify individuals more likely to be at high risk.

It is a basic economic principle that insurance companies charge higher rates for high-risk policyholders to have enough money to pay those claims. It is the main reason for rising premiums in coverage areas with high risks, such as teenage drivers with no prior experience or residents of higher crime areas.

While customers who engage in risky behaviors may be more inclined to purchase insurance policies to cover the costs of a possible injury or illness, these customers are likely to engage in riskier behaviors. As a result, health insurance companies often charge high premiums for customers who engage in risky behaviors.

Simple examples include applicants who understate their risk when applying for coverage and applicants with pre-existing illnesses who apply when they feel healthy. Average claims will increase as the proportion of such low-risk or ill individuals within an insurance pool. To keep costs affordable, insurers must price the insurance such that the average cost of all insured is covered each period.

Another common example of adverse selection is when someone lies about their address or moves to an area with very little crime. If their home state has a high crime rate, they may try to move to an area where they can get auto insurance based purely on the home they select.

Moral Hazard vs. Adverse Selection

Moral hazard occurs when one party of a contract can affect the outcome but chooses not to because of lack of information. On the other hand, adverse selection occurs when one party knows more about itself than what it seems to disclose.

Moral hazard is when one party to a contract takes on the excessive risk because they know that the other party will bail them out even if the worst happens. In banking, for example, managers may become willing to take on enormous risks, knowing that governments will protect them from losses.

The Lemons Problem

The “lemons problem” is a term for a situation where a buyer and a seller have different levels of information, typically leading to the buyer purchasing a poor-quality good at full price.

The Lemons Problem is the concept of quality uncertainty in the market. It was put forward in a 1967 paper by Akerlof.; He introduced the idea of asymmetric information to illustrate how used cars could be seen as defective.

This economist first used the tag phrase to describe this problem. Akerlof’s “lemons problem” is closely related to the adverse selection problem. Using a simple example, Akerlof explains that if buyers can’t tell a good car from a bad one, they will have to pay more for a vehicle, leaving only the worst cars for sale on the market.

The lemons problem is a real-world issue that is present in most businesses/markets. It relates to the gap in the perceived value of investment between buyers and sellers.

In the financial sector there are some instances which demonstrate the lemons problem, for example in the insurance and credit markets. Superior information regarding the actual creditworthiness of a borrower allows lenders to take advantage of borrowers.

Key Takeaways

  • Adverse selection is a phenomenon in market economics in which buyers have information that sellers do not have or vice versa.
  • Adverse selection is a situation in insurance or economics where the insured pool is riskier on average than the general population.
  • Moral hazard occurs when one party of a contract can affect the outcome but chooses not to because of lack of information. On the other hand, adverse selection occurs when one party knows more about itself than what it seems to disclose.
  • The “lemons problem” is a term for a situation where a buyer and a seller have different levels of information, typically leading to the buyer purchasing a poor-quality good at full price.