An adverse selection is a financial transaction in which a negative outcome is experienced as a result of lack of access to information. This term is often used in the insurance industry and is heavily associated with insurance as a result, but it can occur in other markets as well. Nobel laureate George Akerlof is a distinguished figure in the field of studying adverse selection and how it occurs.
This phenomenon is the result of asymmetric information, meaning that one party to a deal has more information about the situation than the other. The party that lacks this information makes a choice on the basis of the information it can access. By doing so, it runs the risk of financial harm as a consequence of the adverse selection.
In the example of insurance, people are more likely to purchase insurance coverage when they know that they will need to make a claim. The more probable a claim, the bigger the policy the customer will apply to obtain. When such a person approaches an insurance company looking for a policy, the insurance company bases the risks of the policy on average people with similar profiles, and sets rates accordingly, not realizing that the customer presents a special risk. If the customer incurs damage and submits a claim, the insurance company becomes the victim of adverse selection.
In the case of a single insurance policy, this may not seem like the end of the world. Insurance companies are, after all, providing a service that is rooted in paying out on claims. However, when insurance companies are primarily patronized by people who know that they will be making claims, the companies may pay out more in claims than they take in in premiums because the premiums are based on average risks. Since the pool of customers self-selects from people at higher risk, the insurance company's average risk assessments are not up to the task of ensuring that everyone pays in enough to cover all claims.
Negative selection, as it is also known, can be combated in a number of ways. One way is by mandating that all parties in a deal have access to relevant information to prevent imbalances of information that result in adverse selection. In the case of insurance, another option is a mandate that forces everyone to get an insurance policy. This spreads the risk across a large pool of people, balancing out the people prone to making claims against the people who do not make claims. However, people who have no need of insurance may argue that it is unfair to force them to buy insurance to pay for others.