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Adverse Selection: Definition, How It Works, and The Lemons Problem

Creator: Jaan Kokk Creator: Jaan Kokk
Creator: Jaan Kokk Creator: Jaan Kokk

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Adverse Selection: What Is It?

In general, the term “adverse selection” refers to a situation in which sellers know about a certain product quality feature but purchasers do not, or vice versa. In other words, it is an instance of the use of asymmetric information. When one side of a transaction has more in-depth knowledge of the relevant facts than the other, this is known as asymmetric information, also known as information failure.

Usually, the vendor is the one who has more knowledge. When both parties are knowledgeable, it is said that there is symmetric information.

Adverse selection in the context of insurance refers to the propensity of people with risky occupations or lifestyles to buy policies like life insurance. In these situations, the purchaser possesses greater knowledge (i.e., regarding their health). Insurance firms limit coverage or increase rates to decrease exposure to significant claims to combat adverse selection.

Adverse Selection: An Understanding
When one party to a negotiation possesses pertinent information, the other party does not, known as adverse selection. Making poor decisions due to knowledge asymmetry, such as expanding into less lucrative or riskier market niches, is common.

Avoiding adverse selection in insurance requires identifying subgroups of people who are more at risk than the overall population and charging them more premiums. For instance, life insurance companies use underwriting to determine whether to offer a policy to a candidate and the appropriate price to charge.

To determine whether the firm can pay a claim, underwriters often consider an applicant’s height, weight, current health, medical history, family history, career, hobbies, driving record, and lifestyle risks like smoking. The insurance provider then decides whether to provide a policy to the applicant and how much to charge as a premium for taking on that risk.

Adverse Selection’s Effects
A vendor can know more about the goods and services offered than a customer, which would disadvantage the buyer. For instance, when managers are aware that a share price is excessive compared to its true value, they may be more ready to issue shares; as a result, investors may wind up purchasing excessively priced shares and incurring losses. In the used car market, a seller may know a vehicle’s flaw and increase the price without disclosing it to the customer.

Due to the informational asymmetry in the market caused by customers’ lack of access to seller or producer-held information, adverse selection generally raises costs. This may result in lesser consumption since consumers may be cautious of the quality of the goods sold. Alternately, it can exclude those customers who lack access to or cannot afford to buy the knowledge that would enable them to make wiser purchasing decisions.

A negative influence on the health and well-being of customers is one indirect outcome of this. Consuming substandard products or harmful medications purchased out of ignorance could result in physical injury. Or, by choosing not to purchase specific medical items (such as immunizations), customers may mistakenly perceive a safe intervention as excessively dangerous.

Adverse Insurance Selection
Due to adverse selection, insurers discover that high-risk individuals are more prone to enroll in policies and pay higher rates. The company suffers a financial loss by paying out more benefits or claims if it charges an average price but only attracts high-risk customers.

However, the company has more cash to pay such benefits because high-risk policyholders pay higher premiums. For instance, race car drivers pay higher premiums for life insurance. Customers of an auto insurance firm that resides in high-crime zones pay extra. Customers who smoke pay higher premiums from a health insurance provider. On the other hand, customers who refrain from dangerous behavior are less inclined to purchase insurance due to rising policy premiums.

A smoker who successfully gets insurance as a nonsmoker is a prime example of adverse selection regarding life or health insurance coverage. Smokers must pay higher premiums to have the same level of coverage as nonsmokers because smoking is a major risk factor for life insurance or health insurance. The applicant is forcing the insurance company to make coverage or premium cost decisions detrimental to its financial risk management by hiding its behavioral decision to smoke.

Another instance of adverse selection in the context of auto insurance would be if a candidate were approved for coverage while living in a neighborhood with a very high crime rate but submitting a dwelling address in a very low one. The likelihood of the applicant’s car being stolen, vandalized, or otherwise damaged is far higher when it is consistently parked in a high-crime area than regularly parked in a low-crime region.

If a candidate claims that the car is always kept in a garage when it is parked on a busy street, adverse selection may occur on a lesser scale.

Tips for Reducing Adverse Selection
reducing asymmetries through increased information access and adverse selection. The Internet has significantly increased access for customers while decreasing expenses. User evaluations, more formal assessments by bloggers or specialized websites, and crowdsourced information are frequently free. They can alert prospective customers to quality flaws that might be difficult to find.

Seller-provided warranties and guarantees are also beneficial because they allow customers to test a product out risk-free for a specified amount of time to determine whether it has any defects or quality problems, and they give them the option to return it risk-free if there are problems. Laws and regulations, like lemon laws in the used automobile business, can also be beneficial. Additionally, federal regulatory agencies like the Food and Drug Administration (FDA) aid in ensuring that goods are both efficient and safe for consumers.

By asking for medical information from candidates through paramedical exams, contacting doctors’ offices for medical records, and looking at one’s family history, insurers lessen adverse selection. This provides the insurance provider with additional information that an applicant might not otherwise disclose.

Moral Danger vs. Discriminatory Hiring
Similar to adverse selection, moral hazard happens when two parties have asymmetric knowledge but when a change in one party’s conduct is revealed after a transaction is made. When there is a lack of symmetric information before a transaction between a buyer and a seller, adverse selection occurs. The possibility that one party did not enter into the agreement in good faith or gave incorrect information about its assets, liabilities, or credit standing is a moral hazard. In the investment banking industry, for example, employees may take on excessive risk to earn lucrative bonuses because they know the bank will be saved even if their risky bets fail. This is because it may become known that government regulatory bodies will bail out failing banks.

The Lemons Issue
The term “lemons problem” describes concerns that develop over a product’s or investment’s worth due to informational inequalities between the customer and the seller.

In a study titled “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism,” economist and University of California, Berkeley professor George A. Akerlof proposed the lemons problem in the late 1960s.
The term used to describe the issue was inspired by the example of old vehicles. Akerlof used the term “lemons,” a term for damaged, used cars, to highlight the idea of asymmetric knowledge. The lesson is that the only used cars available on the market will ultimately be lemons because of adverse selection.

The lemons dilemma, caused by the difference in how consumers and sellers perceive the worth of an investment, affects both the consumer and commercial goods markets and the investing world. The lemons issue is also common in the insurance and credit markets, two financial sector components. For instance, a lender’s knowledge of a borrower’s creditworthiness is asymmetrical and less than ideal in corporate finance.

Why Is Adverse Selection Called That?
“Adverse” denotes something damaging. Therefore, adverse selection occurs when some groups are more at risk than others due to incomplete information. In actuality, it is precisely because of their disadvantage (or advantage) that individuals are chosen (or decide to choose) to engage in a transaction.

What Are the Market Effects of Adverse Selection?
Due to knowledge asymmetries, adverse selection occurs. Economic theory presupposes that all parties have complete and “perfect” information and that markets are efficient. When certain people have access to more information than others, they can often exploit those others to their own cost. Due to these market inefficiencies, prices may rise, or transactions may not occur.

What Is a Trading and Investing Example of Adverse Selection?
There are some inherent knowledge asymmetries in stock markets. Companies that issue shares, for instance, have a better understanding of their internal finances and earnings than the broader public has. This can result in insider trading when people privy to information profit from stock trades before such disclosures are made to the general public.

The inventories of market makers and some institutional traders represent another area of asymmetries. Large shareholders of a company’s stock are disclosed. However, this information is only released once every three months. This indicates that these market participants might have an individual “axe to grind”—a strong urge or desire to buy or sell—not well known to the investing public.


  • When vendors and purchasers have different knowledge about a certain component of a product’s quality, this is referred to as adverse selection.
  • Thus, those who work in hazardous environments or lead high-risk lives are more likely to buy life or disability insurance, knowing they will likely be able to use it.
  • Additionally, a seller may be more knowledgeable than a consumer about the goods and services being supplied, which would disadvantage the buyer in the deal.
  • The adverse selection might be observed in the markets for used vehicles or insurance.

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