Adverse selection refers to a situation in which sellers have information about a product’s quality that buyers do not, or vice versa. In other words, asymmetric information is being exploited. It is also known as information failure. It occurs when one party to a transaction possesses more material knowledge than the other. To know what payment gateways are, click here.
Typically, the seller is the more knowledgeable party. When both parties have equal knowledge, this is referred to as symmetric information.
Key Takeaways
- Adverse selection occurs when sellers have information about a product’s quality that buyers do not, or vice versa
- Those in dangerous jobs or high-risk lifestyles are thus more likely to purchase life or disability insurance where the chances of collecting on it are higher
- A seller may also have more information about the products and services being offered than a buyer, putting the buyer at a disadvantage in the transaction.
Understanding Adverse Selection
When one party in a negotiation has relevant information that the other party does not, this is referred to as adverse selection. Asymmetry of information frequently leads to poor decisions, such as expanding into less profitable or riskier market segments.
In the case of insurance, avoiding adverse selection necessitates identifying groups of people who are more vulnerable. For example, life insurance companies use underwriting to determine whether or not to issue a policy to an applicant and what premium to charge.
Underwriters typically consider an applicant’s height, weight, current health, medical history, family history, occupation, hobbies, driving record. Including lifestyle risks such as smoking. All of these factors have an effect on the applicant’s health and the company’s ability to pay a claim. The insurance company then decides whether or not to issue the applicant a policy and how much to charge for taking on the risk.
Adverse Selection in the Marketplace
A seller may have more information about the products and services being offered than a buyer, putting the buyer at a disadvantage in the transaction.
For example, a company’s managers may be more willing to issue shares when they know the share price is overvalued in comparison to the true value. Buyers may end up purchasing overpriced shares and losing money. In the used car market, a seller may be aware of a vehicle’s flaw and charge the buyer more without disclosing the problem.
Adverse Selection in Insurance
Due to adverse selection, insurers discover that high-risk individuals are more willing to take out and pay higher premiums for policies.
However, by raising premiums for high-risk policyholders, the company has more money to pay those benefits with.
Customers who live in high-crime areas pay a higher premium for car insurance. Customers who smoke face higher premiums from their health insurance provider.
Customers who do not engage in risky behaviours, on the other hand, are less likely to pay for insurance due to rising policy costs.
Adverse Selection vs. Moral Hazard
Moral hazard, like adverse selection, occurs when there is asymmetric information between two parties, but where a change in one party’s behaviour is exposed after a deal is struck. Adverse selection occurs when there is a lack of symmetric information prior to the conclusion of a transaction between a buyer and a seller. Learn more regarding information about bank statement application.
