Adverse Selection

Updated Jan 8, 2023

Definition of Adverse Selection

Adverse selection is a market phenomenon that occurs when buyers and sellers have asymmetric information. That means one party has more information than the other, which can lead to an unfavorable outcome for the less informed party. This can happen in any market, but it is especially common in insurance markets.

Example

To illustrate this, let’s look at an example from the insurance market. Imagine a health insurance company that offers a policy with a fixed premium. Now, if the company does not know the health status of its customers, it will have to assume that all customers are equally healthy. As a result, the company will set the premium at a level that covers the costs of the average customer.

However, customers who are more likely to require expensive treatments are also more likely to purchase insurance. In that case, they have more information about their health than the insurance company. This can lead to a situation where the company is unable to cover its costs, and it may even have to stop offering the policy altogether.

Why Adverse Selection Matters

Adverse selection is an important concept to understand regarding insurance markets. It can lead to a situation where the insurance company cannot cover its costs, which can negatively impact the market as a whole. That’s why insurance companies need to have access to the necessary information to set premiums accurately. Similarly, customers should be aware of the potential for adverse selection when they are shopping for insurance policies.