Reviewed by Sep 30, 2020| Updated on
Adverse selection refers to a situation where the buyers and sellers have asymmetric information. They have different levels of information. One party may have more information than the other. Adverse selection is the opposite of the situation where both the parties have equal information.
Consider this scenario to learn more about adverse selection. In the case of goods and services offered by a seller, the seller has better knowledge about the product than the buyer in terms of any inherent defect in the product or in the performance. In commercial contracts, adverse selection leads to incorrect decisions, thereby, increases the business risks of loss.
The term adverse selection is generally used in the case of insurance contracts where the buyer of the insurance product has more information than the seller of the insurance product. For example, the knowledge about the health of the insured is best known to the insured.
The insured may also hide information deliberately from the insurer. The information may be critical in risk profiling the insured and determining the insurance premium. Insurance companies typically reduce their exposure by limiting the coverage under an insurance contract or by raising the premiums.
In insurance contracts, insurers have to identify groups of people who are subject to more risk than the general population and charge them a higher premium to avoid adverse selection.
Insurance companies generally go for underwriting to evaluate a potential insurance contract, whether to issue a policy and at what premium. Underwriters evaluate the weight, current health, height, medical history, hobbies, lifestyle and so on.
Adverse selection generally arises from the buyer’s tendency to omit disclosures about their risky lifestyles, hobbies, or dangerous job profiles in insurance contracts. In commercial contracts, when the seller has critical information about the product which is concealed from the buyer, it results in an adverse selection for the buyer.