ADVERSE SELECTION

Introduction:  

  • Information is the basis for our economic and financial decisions. As buyers, we collect information about products before entering into a transaction. As investors, the same goes for information about firms seeking our funds. As life insurer (one who sells insurance), we collect information about the life style and diseases an individual has at the time of insurance. 
  • The situation when one party to a transaction has more accurate and different information than the other party, is called adverse selection. This asymmetry of information often leads to making bad decisions. 
  • This term is used in economics, risk management and insurance to describe a situation where the party with less information is at a disadvantage to the party with more information. It is also called anti-selection. 

Explanation with example: 

Let’s assume there are two persons, who are willing to buy life insurance policy. One is a smoker and another is not. It is common knowledge that those who smoke have shorter life expectancies than those who don’t smoke. However, the insurance company cannot differentiate between the individual who smokes and the other person.  

The company will charge the same premium to both the individuals. This leads to adverse selection, where the life insurance company is at a disadvantage. 

Various effects: 

  • Information asymmetry tends to favour the buyer in markets such as the insurance industry.  
  • The seller usually has better information than the buyer in markets such as used cars, stocks, and real estate. 

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