Adverse Selection

Updated on May 9, 2024
Article byIbrahim Zaghw
Reviewed byDheeraj Vaidya, CFA, FRM

What is Adverse Selection?

Adverse selection is an occurrence in the market where one or more parties involved in a deal withhold information that leads to an unfair benefit for one party. This phenomenon can be found mostly in adverse selection insurance where the information about the health condition is withheld from the insurer and the insured gets better benefits than they deserve.

Adverse Selection Definition

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The practice of not delivering full information is done purely with the motive of making larger gains. The ignorant party in the agreement always pays an extra price for their ignorance and in most cases, does not find out about the same until it is too late. 

Key Takeaways

  • Adverse selection occurs when one party takes advantage of the other’s ignorance regarding some piece of information that could potentially put the ignorant party at a loss.
  • It is prevalent when you try to buy something from a seller, like getting a loan with the bank being unaware of your faulty credit rating and advancing you a loan because of this information asymmetry.
  • To solve adverse selection, parties can gather as much information as before the deal is struck or opt for monetary compensation.

Adverse Selection Explained

Adverse selection is when a party has more relevant information than the other party in a transaction, agreement, or negotiation and uses it to its advantage without revealing the information. This asymmetric or unequal access to information ultimately leads to imbalance and market failure.

Let us understand the definition and meaning of adverse selection economics using the concept of information asymmetry and leveraging information asymmetry.

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Information Asymmetry

Information asymmetry is when someone holds information that you don’t know. For instance, if you buy a motorbike from a showroom, there is information asymmetry. This is because the salesperson will be aware of the demerits of buying that motorbike. For example, it has a high maintenance cost, excessive fuel consumption, and a lack of better features.

On the other hand, the buyers are unaware of these drawbacks apart from what the salesperson has told them. They can inspect the motorbike, but there is only so much they will discover without riding it. So, it is likely that the buyers will never figure out the demerits without purchasing the motorbike. This is information asymmetry where the seller had more information than the buyer. This information barrier will hinder informed decision-making by the buyer.

Leveraging Information Asymmetry

The salesperson will inform the buyers about the demerits of the motorbike if they are honest. But if the salesperson hides the demerits and sells them at an overpriced rate, it will be a case of adverse selection. The salesperson leveraged the information asymmetry and successfully sold the motorbike due to the buyer’s ignorance regarding the demerits.

Do not confuse adverse selection and moral hazard as similar concepts. Adverse selection is an incidence of information asymmetry, and moral hazard arises from sharing the wrong information while entering a deal.

Examples

Let us understand adverse selection economics with the help of a few examples. These examples would help us understand the concept in depth.

Example #1

There is often an information asymmetry between the lender and the borrower in corporate finance. For instance, a company could apply for a loan from a bank. However, while the company in question is well aware of its financial situation, the bank itself might have no idea of its creditworthiness or its ability to repay the debt in the future.

As a result, the bank might offer the company favorable terms that are not warranted by its finances. This would be a case of adverse selection.

Example #2

Adverse Selection Example

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  • Adverse selection is common in the insurance industry, where there is excessive information asymmetry. It is also a case where the buyer has more information than the seller. Insurance companies need the information to price their premiums and determine the terms of their policies.
  • They can not afford to charge low premiums to high-risk takers because that would lose them money. This is why life insurance companies will charge smokers more than non-smokers. Smokers are more liable to get life-threatening diseases and are more likely to die early than non-smokers.
  • A heavy smoker can utilize information asymmetry while applying for the policy to get lower premiums. Adverse selection will occur in procuring the insurance to get a better deal if the company extends such a product due to their ignorance of the client’s smoking history.

Example #3

The insurance business by design depends on not only how much they sell but whom they sell their policies. The very reason some of the insurance procedures and waiting lists are too long and customers constantly complain is designed by insurance companies to avoid adverse selections.

As a result, open enrolment period exists only for a very limited period so that individuals do not wait for a health-related issue to arise before they enrol themselves to an insurance scheme.

The very reason insurance exists is to create a buffer source of finance in a difficult situation. However, many if not most insurance seekers wait to enrol or upgrade their insurance right before they know expenses for a particular cause might arise, shows an MIT study.

How to solve?

The problem with adverse selection insurance policies and other such cases in market places is that they have the unfortunate potential to wipe out an entire industry. However, it is not an issue that cannot be solved. Let us understand how to solve this issue through the explanation below.

  1. The most obvious solution is for the disadvantaged party to find out all the information. This is why insurance companies hire underwriters who investigate insurance applicants and ensure that what is said on the application matches reality.
  2. It could also be solved financially, with the disadvantaged party getting compensated for taking on more risk than the party possessing better knowledge. If an insurance company feels that an individual may utilize information asymmetry to their benefit, the company can increase the premiums. Even if the applicant isn’t honest about their situation, the company will not be undercharged.
  3. On the other hand, parties that do a deal could restructure to mitigate the risks of leveraging information asymmetry. For example, to prevent being cheated, the motorbike buyer from the above example can suggest test-driving a couple of times before making a purchase decision.

Adverse Selection Vs Moral Hazard

Both adverse selection economics and moral hazard deal with misleading or concealing information with the parties involved in a transaction, agreement, or negotiation. However, there are fundamental differences in these concepts, and thereby, their implications are different as well. Let us understand the differences through the comparison below.

Adverse Selection

  • It is a scenario where one party has more relevant information than the other party and they conceal it to make bigger gains than they deserve from the agreement or transaction.
  • These scenarios occur before the transaction is completed.
  • One party uses the other party’s ignorance or lack of knowledge to their benefit.

Moral Hazard

  • Moral Hazard is when a party entering into an agreement or contract gives misleading information to the other party that leads to the mishap of the entire agreement after it has begun.
  • These scenarios occur after the agreement or transaction is completed.
  • Here, the party giving misleading information knowingly deceives the other party knowing the consequences beforehand.

Frequently Asked Questions (FAQs)

What distinguishes moral hazard from the adverse selection?

The concept known as “adverse selection” states that bad risks are more likely than good risks to purchase insurance. The phenomenon known as moral hazard describes how having insurance may alter one’s conduct.

How do you handle adverse selection?

Bridging the perceived information gap between the two parties by assisting them in learning as much as possible is one technique to do this.

What impact does negative selection have on the financial market?

Adverse selection happens when buyers and sellers have asymmetric (unequal) knowledge. Due to this unequal information, the market is distorted and fails.

This has been a guide to what is Adverse Selection. Here we explain its examples, how to solve this problem and compare it with moral hazard. You can learn more from the following articles –