What Is Adverse Selection?

Adverse selection refers to a situation in which sellers have information🌠 that buyers do not have, or vice versa. This asymme♑tric information can then be exploited.

澳洲幸运5官方开奖结果体彩网:Asymmetric information, also called information failure, occurs when one party to a transaction has greater material knowledge than the other, typically about product quality. Symmetric information is when both parties have equ✱al knowledge. Usually, the more knowledgea𒊎ble party is the seller.

In the case of 澳洲幸运5官方开奖结果体彩网:insurance, adverse selection is the tendency of those in dangerous jobs or high-risk lifestyles to purchase products like 澳洲幸运5官方开奖结果体彩网:life insurance. In these cases, it is the buyer who actually has more knowledge. To fight adverse selection, insurance companies reduce exposure to large claims by limiti𝔉ng coverage or raising premiums♊.

Understanding Adverse Selection

Adverse selection occurs when one party in a negotiation has relevant information the other party lacks. The asymmetry of information often leads to poor decisions, such as the choice to do more business with less profitable or riskier 澳洲幸运5官方开奖结果体彩网:market segments.

In the case of insurance, avoiding adverse selection requires identifying groups of people more at risk than the general population and charging them more money. For example, life insurance companies go through underwriting when evaluating whether to give an applicant a policy and what premium to charge.

澳洲幸运5官方开奖结果体彩网:Underwriters typically evaluate an applicant’s height, weight🍸, current health, medical history, family history, occupation, hobbie🃏s, driving record, and lifestyle risks such as smoking. All these issues impact an applicant’s health and the company’s potential for paying a claim. The insurance company then determines whether to give the applicant a policy and what premium to charge for taking on that risk.

Consequences of Adverse Selection

A seller may have better information than a buyer about products and services being offered, putting the buyer at a disadvantage in the transaction. For example, a company’s managers may more willingly issue shares when they know the share price is overvalued compared to the 澳洲幸运5官方开奖结果体彩网:real value; buyers can end ✱up buying overvalued shares and lose money. In the secondhand car market, a seller may know about a vehicle’s defect and charge the buyer more without disclosing the issue.

The general consequence of adverse selection is that it increases costs since consumers lack information held by sellers or producers, creating an asymmetry in the market. This can also lower❀ consumption as buyers may be wary of the quality of the products that are offered for sale. Or, it may exclude certain consumers that do not have access to or cannot afford to𝓀 obtain information that could lead them to make better buying decisions.

One indirect effect of this is a negative impact on consumers' health and well-being. If you buy a faulty product or dangerous medication because you don't have good information, consuming these products can cause physical harm. Similarly, by refraining from buying certain healthcare products, such as medicines or vaccines, consumers may wrongly judge a safe intervention as overly risky.

Adverse Selection in Insurance

Because of adverse selection, insurers find that high-risk people are more willing to take out and pay greater premiums for policies. If the company charges an average premium for insurance but only high-risk consumers enroll, then the company takes a financial loss by paying out more in benefits or claims.

By increasing premiums for high-risk policyholders, the company has more money with which to pay those benefits. For example, a life insurance company charges higher premiums for race car drivers. A car insurance company charges more for customers living in high-crime areas. A 澳洲幸运5官方开奖结果体彩网:health insurance company charges higher premiums for customers who smoke. In contrast, customers who do nꦐot engage in risky behaviors are less likely to pay for insurance due to increasing policy costs.

A prime example of adverse selection in regard to life or health insurance coverage is a smoker who successfully manages to obtain insurance coverage as a nonsmoker. Smoking is a key identified risk factor for life insurance or health insurance, so a smoker must pay higher premiums to obtain the same coverage level as a nonsmoker. By concealing their behavioral choice to smoke, an applicant is leading the insurance company to make decisions on coverage or premium costs that are adverse to the insurance company's management of financial risk.

Another example of adverse selection in the case of 澳洲幸运5官方开奖结果体彩网:auto insurance would be a situation where the applicant obtains insurance coverage based on providing a residence address in an area with a very low crime rate when the applicant actually lives in an area with a very high crime rate. Obviously, the risk of the applicant's vehicle being stolen, vandalized, or otherwise damaged w♒hen regularly parked in a hig♈h-crime area is substantially greater than if the vehicle was regularly parked in a low-crime area.

How to Minimize Adverse Selection

Both sellers and buyers can reduce adverse selection by increasing access to information, thus minimizing asymmetries. For consumers, the internet has greatly increased access while reduc📖ing costs. Crowd-sourced information in the form of user reviews along with more formal reviews by bloggers or specialist websites are often free and warn potential buyers about otherwise obscure issues around quality.

Warranties and guarantees offered by sellers can also help, allowing consumers to use a product risk-free for a certain period to see if it has flaws or quality issues and to return them without consequence if any arise. Laws and regulations can also help, such as Lemon Laws in the used car industry. Federal regulatory authorities such as the 澳洲幸运5官方开奖结果体彩网:Food and Drug Administration (FDA) also 🍬help ensure that prodꦕucts are safe and effective for consumers.

Insurers reduce adverse selection by requesting medical information from applicants in the form of requiring paramedical examinations, querying doctors' offices for medical records, and looking at one's family history. This gives the insurance company more information that an applicant may fail to disclose on their own.

Moral Hazard vs. Adverse Selection

Moral hazard is the risk that one party has not entered into a contract in 澳洲幸运5官方开奖结果体彩网:good faith or has previously provided false details a🗹bout its assets, liabilities, or credit capacity.ജ

Like adverse selection, 澳洲幸运5官方开奖结果体彩网:moral hazard occurs when there is asymmetric information between two parties. However, adverse selection occurs when there's a lack of symmetric information prior to a deal between a buyer and a seller, and moral haza𝐆rd occurs after a deal is struck.

For instance, in the 澳洲幸运5官方开奖结果体彩网:investment banking sector, it may become known that government regulatory bodies will bail out failing banks; as a result, bank employees may take on excessive amounts of risk to score lucꦦrative bonus💮es knowing that if their risky bets do not pan out, the bank will be saved anyhow.

The Lemons Problem

The 澳洲幸运5官方开奖结果体彩网:lemons problem refers to issues that arise regar🧸ding the value of an investment or produ📖ct due to asymmetric information possessed by the buyer and the seller.

The lemons problem was put forward in a research paper, "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism," written in the late 1960s by George A. Akerlof, an economist and professor at the University of California, Berkeley. The tag phrase identifying the problem came from the example of used cars Akerlof used to illustrate the concept of asymmetric information, as defective used cars are commonly referred to as lemons. The takeaway is that due to adverse selection, the only used cars left on the market will🗹 ultimately be lemons.

The lemons problem exists in the marketplace for both consumer and business products, and also in the arena of investing, related to the disparity in the perceived value of an investment between buyers and sellers. The lemons problem is also prevalent in financial sector areas, including insurance and credit markets. For example, in the realm of corporate finance, a lender has asymmetrical and less-than-ideal information regarding the actual 澳洲幸运5官方开奖结果体彩网:creditworthiness of a borrower.

The Bottom Line

Contrary to assumptions made by mainstream economic and financial models, information is not symmetrically accessible and available to all actors in a market. In particular, sellers and producers often have far more information about what they are selling than do buyers. This information asymmetry can lead to market inefficiencies via what is known as adverse selection. In in𓄧surance markets, applicants have more information about themselves than do insurers, meaning that they withhold key information about being higher-risk.