Definition of adverse selection
What is adverse selection?
Adverse selection usually refers to a situation where sellers have information that buyers do not have, or vice versa, about some aspect of product quality. In other words, this is a case where asymmetric information is exploited. Asymmetric information, also known as information failure, occurs when one party to a transaction has greater material knowledge than the other party.
Usually, the most knowledgeable party is the seller. Symmetric information is when both parties have equal knowledge.
In the case of insurance, adverse selection is the tendency for those in dangerous jobs or high risk lifestyles to purchase products like life insurance. In these cases, it is the buyer who actually has more knowledge (i.e. about his health). To combat adverse selection, insurance companies reduce exposure to large claims by limiting coverage or increasing premiums.
Key points to remember
- Adverse selection occurs when sellers have information that buyers do not have, or vice versa, about some aspect of product quality.
- So it is the tendency of those in dangerous jobs or high risk lifestyles to purchase life insurance or disability insurance where the chances are greater that they will benefit from it.
- A seller may also have better information than a buyer about the products and services offered, which puts the buyer at a disadvantage in the transaction. For example in the used car market.
Understanding adverse selection
Antiselection occurs when one party to a negotiation has relevant information that the other party does not have. Information asymmetry often leads to poor decisions, such as doing more business with less profitable or more risky market segments.
In the case of insurance, avoiding adverse selection requires identifying groups of people at greater risk than the general population and charging them more. For example, life insurance companies underwrite when considering whether to give a policy to a claimant and what premium to charge.
Underwriters typically assess the applicant’s height, weight, current health, medical history, family history, occupation, hobbies, driving record, and lifestyle risks such as smoking; all of these issues have an impact on the health of a claimant and the potential of the business to pay a claim. The insurance company then determines whether to give the claimant a policy and what premium to charge to assume that risk.
Adverse selection in the market
A seller may have better information than a buyer about the products and services offered, which puts the buyer at a disadvantage in the transaction. For example, managers of a company may more readily issue shares when they know that the share price is overvalued relative to the real value; buyers can end up buying overvalued stocks and lose money. In the used car market, a seller may be aware of a vehicle’s defect and charge the buyer more without disclosing the problem.
Adverse selection in insurance
Due to adverse selection, insurers find that high risk people are more willing to underwrite and pay higher premiums for policies. If the business charges an average price but only high-risk consumers buy, the business suffers a financial loss by paying more benefits or claims.
However, by increasing premiums for high-risk policyholders, the company has more money to pay for these benefits. For example, a life insurance company charges higher premiums to drivers of racing cars. An auto insurance company charges more for customers living in high crime areas. A health insurance company charges higher premiums for customers who smoke. In contrast, clients who do not engage in risky behavior are less likely to pay for insurance due to increased policy costs.
A prime example of adverse selection for life insurance or health insurance coverage is a smoker who successfully obtains insurance coverage as a non-smoker. Smoking is a key risk factor identified for life insurance or health insurance, so a smoker has to pay higher premiums to get the same level of coverage as a non-smoker. By concealing their behavioral choice to smoke, an applicant causes the insurance company to make decisions about coverage or premium costs that are unfavorable to the management of financial risk by the insurance company.
Another example of adverse selection in the case of auto insurance would be a situation where the applicant obtains insurance coverage based on providing a residence address in a very low crime area while the applicant lives really in an area with a very high crime rate. . Obviously, the risk of the applicant’s vehicle being stolen, vandalized or otherwise damaged when regularly parked in a high crime area is significantly higher than if the vehicle was regularly parked in a low crime area.
Antiselection can occur on a smaller scale if an applicant states that the vehicle is parked in a garage every night when it is in fact parked on a busy street.
Moral risk vs. adverse selection
Like adverse selection, moral hazard occurs when there is asymmetric information between two parties, but when a change in one party’s behavior is exhibited after an agreement is reached. Adverse selection occurs when there is a lack of symmetrical information before to an agreement between a buyer and a seller.
Moral hazard is the risk that one party has not entered into the contract in good faith or has provided false details about its assets, liabilities or credit capacity. For example, in the investment banking industry, it may be known that government regulators will bail out failing banks; as a result, bank employees may take excessive risks to get lucrative bonuses knowing that if their risky bets do not materialize, the bank will be saved anyway.
The problem of lemons
The lemons problem refers to issues that arise regarding the value of an investment or product due to asymmetric information held by the buyer and seller.
The problem of lemons was brought to the fore in a research paper titled âThe Market for ‘Lemons’: Uncertainty of Quality and Market Mechanism,â written in the late 1960s by George A. Akerlof, economist and professor at the University of California at Berkeley. The tag phrase identifying the problem came from the used car example that Akerlof used to illustrate the concept of asymmetric information, as defective used cars are commonly referred to as lemons.
The problem of lemons exists in the consumer and commercial product market, as well as in the investment arena, related to the disparity in the perceived value of an investment between buyers and sellers. The problem of lemons is also prevalent in areas of the financial sector, including the insurance and credit markets. For example, in corporate finance, a lender has asymmetric and less than ideal information about a borrower’s actual creditworthiness.