What is Adverse Selection?

Adverse selection occurs when one party in a transaction has information that the other party does not have, which can then be exploited. This scenario of asymmetric information, also known as information failure, typically involves one party having significantly more material knowledge than the other, often regarding product quality. Symmetric information, on the other hand, is when both parties possess equal knowledge. In many cases, the more knowledgeable party is the seller.

In the context of insurance, adverse selection manifests as individuals in high-risk jobs or with high-risk lifestyles being more likely to purchase products like life insurance. Here, the buyer has more relevant knowledge. To mitigate adverse selection, insurance companies may limit coverage or increase premiums to reduce exposure to large claims.

Key points:

• Adverse selection happens when sellers or buyers have more information about some aspect of product quality than the other party.
• It often involves individuals in risky jobs or lifestyles purchasing life or disability insurance, where they are more likely to make a claim.
• Sellers might have better information than buyers about products and services, disadvantaging the buyer in transactions.
• Adverse selection is commonly observed in markets for used cars and insurance.

How Adverse Selection Works

Adverse selection arises when one party in a negotiation possesses relevant information that the other party lacks. This information asymmetry often results in suboptimal decisions, such as engaging more with less profitable or riskier market segments.

In the context of insurance, mitigating adverse selection involves identifying higher-risk groups and charging them higher premiums. For instance, life insurance companies perform underwriting to evaluate whether to offer an applicant a policy and determine the appropriate premium.

Underwriters assess various factors including an applicant’s height, weight, current health, medical history, family history, occupation, hobbies, driving record, and lifestyle risks like smoking. These factors influence the applicant’s health and the likelihood of the company needing to pay a claim. Based on this evaluation, the insurance company decides whether to issue a policy and the premium to charge for the associated risk.

Consequences of Adverse Selection

A seller often has more information about products and services than the buyer, which can disadvantage the buyer. For instance, company managers might issue shares knowing the share price is overvalued, leading buyers to purchase overvalued shares and incur losses. In the secondhand car market, a seller may conceal a vehicle’s defect and overcharge the buyer.

Adverse selection generally increases costs due to the information asymmetry between consumers and sellers or producers. This disparity can decrease consumption as buyers become cautious about product quality. Additionally, it may exclude consumers who cannot afford or access information necessary for making informed purchasing decisions.

An indirect consequence of adverse selection is its negative impact on consumer health and well-being. Purchasing faulty products or dangerous medications due to inadequate information can cause physical harm. Conversely, avoiding certain healthcare products, such as medicines or vaccines, based on incorrect perceptions of risk can also be detrimental.

Example of Adverse Selection – Insurance

Adverse selection leads insurers to find that high-risk individuals are more inclined to purchase and pay higher premiums for policies. If an insurer sets an average premium but only high-risk consumers enrol, the insurer may suffer financial losses due to increased benefit payouts.

To mitigate this, insurers raise premiums for high-risk policyholders, thereby accumulating more funds to cover these higher claims. For instance, life insurance companies charge higher premiums for race car drivers, car insurance companies charge more for residents of high-crime areas, and health insurance companies charge higher premiums for smokers. Consequently, individuals who avoid risky behaviours are less likely to purchase insurance due to rising costs.

An example of adverse selection in life or health insurance is a smoker who secures coverage by falsely claiming to be a nonsmoker. Smoking is a significant risk factor, so smokers must pay higher premiums to match the coverage level of nonsmokers. By hiding their smoking habit, the applicant causes the insurance company to make coverage and premium decisions that undermine its financial risk management.

In auto insurance, adverse selection occurs when an applicant provides an address in a low-crime area to obtain coverage but actually lives in a high-crime area. The risk of the vehicle being stolen, vandalised, or damaged is much higher in a high-crime area than in a low-crime area, leading to potential financial losses for the insurer.

How to Minimise Adverse Selection

Both sellers and buyers can mitigate adverse selection by improving access to information, thereby reducing asymmetries. For consumers, the internet has significantly increased access while lowering costs. Crowd-sourced information, such as user reviews, and formal reviews by bloggers or specialist websites, are often free and alert potential buyers to otherwise obscure quality issues.

Warranties and guarantees provided by sellers also play a role, allowing consumers to test a product risk-free for a certain period and return it without penalty if flaws or quality issues arise. Additionally, laws and regulations, such as Lemon Laws in the used car industry, provide further protection. Federal regulatory authorities, like the Food and Drug Administration (FDA), ensure that products are safe and effective for consumers.

Insurers mitigate adverse selection by gathering medical information from applicants. This includes requiring paramedical examinations, querying doctors’ offices for medical records, and reviewing family history. This process provides the insurance company with more information that applicants may not disclose on their own.

Moral Hazard vs. Adverse Selection

Moral hazard refers to the risk that one party may not have entered into a contract with good intentions or may have misrepresented their financial situation, such as assets, liabilities, or credit capacity.

Similar to adverse selection, moral hazard arises from asymmetric information between two parties. However, adverse selection occurs when there is a lack of balanced information before a transaction between a buyer and a seller, while moral hazard takes place after the transaction has been made.

For example, in the investment banking sector, if it’s known that government regulatory bodies will rescue failing banks, bank employees might engage in excessively risky behaviours to earn large bonuses. They do this knowing that if their risky bets fail, the bank will still be bailed out.

What is the Lemons Problem?

The lemons problem arises from issues related to the value of an investment or product due to asymmetric information between the buyer and the seller. This concept was introduced by George A. Akerlof in his late 1960s research paper, “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism.” Akerlof, an economist and professor at the University of California, Berkeley, used the example of defective used cars, commonly referred to as lemons, to illustrate the concept of asymmetric information. He showed that adverse selection can result in only lemons being left on the market.

This problem is found in both consumer and business markets and extends to the investment sector, where there is often a disparity in the perceived value of an investment between buyers and sellers. The lemons problem is also prevalent in financial areas, including insurance and credit markets. For instance, in corporate finance, lenders often have less-than-ideal information about the actual creditworthiness of borrowers, leading to asymmetric information issues.

Conclusion

Contrary to assumptions made by mainstream economic and financial models, information is not equally accessible and available to all market participants. Sellers and producers typically possess significantly more information about their products than buyers do. This information asymmetry can result in market inefficiencies through a phenomenon known as adverse selection. In insurance markets, for instance, applicants often have more knowledge about their own risk factors than insurers do, which allows them to withhold critical information that may indicate higher risk.

DISCLAIMER: This article is for informational purposes only and is the opinion of the author. BARTERCARD is not affiliated with any company or government office.