what is adverse selection 
adverse selection refers to a situation in which sellers have information that buyers do not have or vice versa this asymmetric information can then be exploited 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 equal knowledge usually the more knowledgeable party is the seller in the case of insurance adverse selection is the tendency of those in dangerous jobs or high risk lifestyles to purchase products like 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 limiting coverage or raising premiums investopedia jiaqi zhouunderstanding adverse selectionadverse 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 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 underwriters typically evaluate an applicant s height weight current health medical history family history occupation hobbies 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 selectiona 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 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 to 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 insurancebecause 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 health insurance company charges higher premiums for customers who smoke in contrast customers who do not 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 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 when regularly parked in a high crime area is substantially greater than if the vehicle was regularly parked in a low crime area adverse selection might occur on a smaller scale if an applicant states that the vehicle is parked in a garage every night when it is actually parked on a busy street 