What Is 'Adverse Selection'
Adverse selection is a term used in economics and insurance to describe a situation where one party has more information than the other party, which results in the less informed party experiencing negative consequences.
In the context of insurance, adverse selection occurs when individuals with a higher risk of making a claim are more likely to purchase insurance, while those with a lower risk are less likely to purchase insurance. This is because the individuals with a higher risk of making a claim stand to benefit more from insurance than those with a lower risk. As a result, insurance companies may end up insuring a pool of individuals who are more likely to make claims, which can result in higher costs for the insurance company and higher premiums for policyholders.
For example, imagine a health insurance company that offers a policy that covers the cost of medical treatments for cancer. Suppose individuals who are at a higher risk of developing cancer are more likely to purchase the policy. In that case, the insurance company may end up insuring a pool of individuals who are more likely to develop cancer. This means that the insurance company may have to pay out more claims, which can result in higher premiums for policyholders.
Adverse selection can also occur in markets where the seller has more information than the buyer. For example, imagine a used car market where the seller knows more about the condition of the car than the buyer. If the seller knows that the car has mechanical issues, they may be more likely to sell it to a buyer who is less informed about the car's condition. This can result in the buyer experiencing negative consequences, such as having to pay for expensive repairs or purchasing an unsafe car.
Insurance companies and other market participants may use various strategies to address adverse selection to encourage a more balanced risk pool. For example, insurance companies may offer different policies with varying levels of coverage and premiums to attract a wider range of individuals. They may also use risk assessments and underwriting to determine an individual's risk level and adjust their premiums accordingly.
In conclusion, adverse selection is when one party has more information than the other, which can result in negative consequences for the less informed party. Adverse selection is commonly observed in insurance markets, leading to higher premiums for policyholders and higher costs for insurance companies. Insurance companies and other market participants may use various strategies to address adverse selection to encourage a more balanced risk pool.
