What is Adverse Selection?
539 Views · Updated December 5, 2024
Adverse selection refers generally to a situation in which sellers have information that buyers do not have, or vice versa, about some aspect of product quality. In other words, it is a case where asymmetric information is exploited. Asymmetric information, also called information failure, happens when one party to a transaction has greater material knowledge than the other party.Typically, the more knowledgeable party is the seller. Symmetric information is when both parties have equal knowledge.In the case of insurance, adverse selection is the tendency of 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 their health). To fight adverse selection, insurance companies reduce exposure to large claims by limiting coverage or raising premiums.
Definition
Adverse selection refers to a situation where one party in a transaction has more or better information than the other, typically about the quality of the product. This is a case of asymmetric information, where one party possesses more substantial knowledge than the other.
Origin
The concept of adverse selection was first introduced by economist George Akerlof in 1970 in his paper "The Market for Lemons," which explored the issue of information asymmetry in the used car market. Akerlof's work highlighted how asymmetric information can lead to market failure, earning him the Nobel Prize in Economics in 2001.
Categories and Features
Adverse selection is prevalent in insurance and financial markets. In insurance, it refers to the tendency of high-risk individuals to purchase insurance because they are more likely to benefit from it. In financial markets, adverse selection can lead to the over-purchase of poor-quality investment products because investors cannot accurately assess their true value. A key feature of adverse selection is that it reduces market efficiency and can even lead to market collapse.
Case Studies
A typical case is the U.S. health insurance market, where high-risk individuals are more likely to buy health insurance, leading to higher payout risks for insurers. Another example is during the subprime mortgage crisis, where many investors purchased high-risk mortgage-backed securities because they could not accurately assess the risks involved.
Common Issues
Investors often face the problem of asymmetric information when dealing with adverse selection, making it difficult to make informed decisions. A common misconception is that all market participants have the same information, whereas asymmetric information is widespread. To combat adverse selection, investors should seek to gather as much information as possible and rely on professional advice.
Disclaimer: This content is for informational and educational purposes only and does not constitute a recommendation and endorsement of any specific investment or investment strategy.