Adverse Selection

Adverse selection is a term used in economics and insurance in reference to a market process in which buyers or sellers of a product or service are able to use their private knowledge of the risk factors involved in the transaction to maximize their outcomes, usually at the expense of the other parties to the transaction. The concept of adverse selection was first used predominantly in the insurance industry to describe the greater likelihood that the people who elect to purchase insurance policies are more likely to file claims that will, over the life of the policy, exceed the total dollar value of the premiums that they pay.

The individuals who elect to purchase insurance know that they have higher risk factors than the population norm that enhance the chance that they will file future claims. If insurers use the risk factors of the general population to set premiums, they will lose money when the number of individuals who file claims exceeds the population norm. If insurers raise the cost of premiums to cover the increased claims, they also increase the likelihood that individuals who know that they are less likely to file future claims will opt out of the plan, increasing the number of individuals remaining in the plan that will file claims.

Insurers may also use adverse selection to their financial advantage. If insurers have the ability to deny coverage to individuals who are deemed “high risk,” they will try to avoid insuring all individuals except for those believed to be least likely to file future claims. This practice, known as “cherry picking” or “cream skimming,” may result in insurers providing coverage to a group of individuals who are less likely to file claims than the population norm, thereby increasing the insurers' profits. In these instances, the costs incurred by the higher-risk individuals are generally borne by society. To combat this practice, the government may forbid insurers to act on information about their population even if they are able to discover it. For example, some U.S. states require health insurance providers to insure all who apply at the same cost, regardless of their individual risk factors.

Adverse selection is most likely to occur in situations in which there is an asymmetry of information. In economics, information asymmetry occurs when one party to a transaction has more or better information than the other party. While information asummetry tends to favor the buyer in the insurance industry, the concept of adverse selection has been expanded by economists into numerous markets other than insurance where similar asymmetries of information may exist that tend to favor the seller. Examples of situations where the seller usually has better information than the buyer include used-car sales, stock, and real estate.