Adverse Selection

Adverse Selection Definition

Adverse selection occurs when one party takes advantage of the other when they hold back some information that could potentially put the ignorant party as a loss. An example of adverse selection is when a company takes advantage of the buyers ignorance regarding the demerits of a financial asset introduced by them.

Resultantly, they succeed in selling it to an unsuspecting buyer by using this information asymmetry.

Key Takeaways
  • Adverse selection occurs when one party takes advantage of the other’s ignorance regarding some piece information that could potentially put the ignorant party as 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 hence advancing you a loan on account of this information asymmetry.
  • To solve adverse selection, parties can gather as much information as they can before the deal is struck or opt for monetary compensation.

How does Adverse Selection work?

Let us understand the definition and meaning of adverse selection using the concept of information asymmetryInformation AsymmetryAsymmetric information is the knowledge mismatch that happens when one party secures more information about a product or service than the other party to the transaction. The information failure is often seen when the seller is more informed about a product's condition than the buyer.read more and leveraging information asymmetry.

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 will be some information asymmetry. The salesperson will be aware of the demerits of buying that motorbike such as it having 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 an 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 it at an overpriced rate, then it will be a case of adverse selection. This is because 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 a similar concept. Adverse selection is an incidence of information asymmetry, and moral hazard arises from sharing the wrong information while entering a deal.

Adverse Selection Example

Let’s look at some examples.

Adverse Selection

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For eg:
Source: Adverse Selection (wallstreetmojo.com)

#1 – Corporate Finance

In Corporate Finance, there is often an information asymmetry between the lender and the borrower. For instance, a company could apply for a loan from a bank. 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.

#2 – Insurance Industry

  • Adverse selection is common in the insurance industry, where there is excessive information asymmetry. It is also a case where the buyer is the one with 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 at risk of dying 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.

How to solve the Adverse Selection Problem?

There are a few ways to deal with it which are listed below.

  1. The most obvious solution is for the disadvantaged party to find out all the information it is lacking. This is why insurance companies hire underwriters who investigate insurance applicants and make sure 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 be trying to 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 to a deal could restructure the deal 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.

This has been a guide to Adverse Selection Definition. Here we discuss how does it work along with some real-life examples and how to handle it. You can learn more from the following articles –