Updated July 10, 2023
Introduction of Adverse Selection
Adverse selection is a situation where one party to the transaction has more knowledge than the other party. This is a case of Asymmetric information (i.e.) information failure where one party has more detailed knowledge and understanding and is at a disadvantage.
This information and knowledge gap can disturb the market and lead to market failure.
How Does Adverse Selection Work?
It happens when both parties to the transaction do not have equal knowledge. It puts one party to the transaction at an advantage with more relevant information and the other at a disadvantage. This situation leads to bad decision-making as one party has lesser knowledge, resulting in loss-making or less profit. This leads to a riskier marketplace as one party is at the gain, and the other is a loss and ineffective price management. It may even lead to market collapse. Adverse selection happens mostly in the insurance sector, where people in high-risk jobs and life take cover to protect themselves from risk.
Causes of Adverse Selection
A lack of relevant knowledge and unequal information to both parties primarily causes adverse selection. When one party has more relevant information, it leads to biased decisions and disrupts the market. Examples of a few instances which cause adverse selection.
- When selling second-hand goods, the seller has more knowledge and information about the products/goods than the buyer, who may have limited knowledge. Therefore, this is a case of adverse selection as both parties to the transaction do not have equal knowledge.
- In the case of insurance, the insurance companies have very limited knowledge about the applicant (in case of health insurance/Life insurance) and the vehicle (in case of vehicle/auto insurance). Therefore, the insurance company is at a disadvantage here, which is a case of an adverse selection.
- In the case of the capital market, the management of the company is better aware of the company’s performance than the public investors, they may offer the shares to the public at a higher price, and the investors are at risk as they do not have complete information and end up making a loss on investment.
Solutions for Adverse Selection
Certain steps can avoid adverse selection in different situations.
- In the case of insurance, adverse selection can avoid by getting the right information from the applicant and making the correct assessment. Then, based on the assessment, they can charge the right premium and restrict the coverage. On the other hand, underwriting is a process where insurance companies let the underwriters assess the applicants, and based on the assessment, they can decide on providing the policy.
- Any party with limited or restricted information can consult a subject-matter expert.
Adverse Selection in Insurance
Any party with limited or restricted information can consult a subject-matter expert. Adverse Selection in Insurance happens because the Insurance Company is at riskier if they do not charge the right premium and provide the right coverage to the policyholders based on their risk profile. In addition, they may lose money if they don’t know enough about the applicant before issuing the policy.
For example, in the case of life insurance and health insurance, the company has to assess the applicant’s health condition and other habits completely to decide on the premium payment and coverage. The insurance company charges a higher premium to individuals with poor health habits, such as being an alcoholic or smoker, as they pose a higher risk of health issues and potential claims. Conversely, applicants who are teetotalers and physically fit carry a lesser risk, resulting in a lower premium being charged.
In the case of vehicle insurance, the usage of vehicles, the city of residence, etc., are considered before deciding on the insurance premium and coverage. For example, in the case of vehicles used in high-crime cities, the chance of vehicles getting lost and damaged is high, putting the insurance company at a loss. Therefore, considering the situation, a higher premium is charged for those cases than for the vehicles in other cities.
Examples of Adverse Selection
“ABC Corporation” is a life insurance company; Mr. X is a car racer; considering the risky job profile, he wishes to take a life insurance policy. Before a policy is issued to Mr. X, ABC Corporation has to assess his risk profile, like job risk, health conditions, etc. In this case, car racing is risky; the insurance premium will be high for Mr. X compared to other applicants with low-risk job profiles and the same health condition. The insurance coverage will also vary based on the risk profile.
“Z Corporation” is an insurance company that even covers vehicle insurance. Mr. Y wants to ensure his car. He approaches Z Corporation for the same; before providing the policy, the company has to evaluate the usage of the car, the history of the driver and car-like accidents and damages caused, the city in which they reside, etc. The insurance company obtains and evaluates all this information thoroughly before issuing the insurance policy, determining the premium based on the risk profile, and setting the coverage.
The adverse selection indicates that the party with limited knowledge of a transaction should take the necessary steps to get complete information before entering the transaction. Adverse selection prevailing can disrupt the market ecosystem as it may cause people to hesitate to enter the market due to the potential loss of money without the right information, putting them at a disadvantage. Therefore, adverse selection should be minimal to have a proper marketplace and build economic activities.
It is a situation that cannot be completely avoided as all the parties to the transaction may not have complete knowledge and information. Still, it can be restricted by taking proper measures and steps to avoid the situations. For example, underwriting helps avoid adverse selection; in the case of any second-hand car purchase, a car expert can be accompanied to decide the right purchase price. So, taking the right preventive measures can limit adverse selection.
This is a guide to Adverse Selection. Here we also discuss the introduction and How Adverse Selection Works? Along with an example. You may also have a look at the following articles to learn more –