Adverse Selection
IntermediateAdverse selection is a situation in which one party in a transaction has more information than the other, leading to a higher likelihood of attracting the wrong type of participant, such as high-risk customers in insurance or poor-quality goods in a market.
Adverse selection arises from information asymmetry, when buyers and sellers do not have equal knowledge. It happens before a transaction takes place, unlike moral hazard, which concerns behaviour after an agreement is made.
In health insurance, people who know they are likely to need medical care are more eager to buy insurance than those who expect to stay healthy. If the insurer cannot tell them apart and charges everyone the same price, it will attract more high-risk customers, so claims rise, premiums must increase, and healthy people drop out, worsening the problem.
A famous example is the used car market described by economist George Akerlof. Sellers know whether their car is reliable, but buyers do not. Fearing they might buy a poor-quality car, buyers offer lower prices, which drives sellers of good cars out of the market.
Ways to reduce adverse selection include medical questionnaires and underwriting, warranties, independent inspections, credit checks, and in some cases requiring everyone to participate, as in compulsory insurance schemes.
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