What is Adverse Selection?

Adverse selection refers to a scenario where either the buyer or the seller has information
about an aspect of product quality that the other party does not have. Adverse selection is a
common scenario in the insurance sector, where people in high-risk lifestyles or those
engaged in dangerous jobs sign up for a life insurance cover as a way of protecting
themselves from the impending risk.

Insurance companies, on the other hand, reduce their exposure to such high-risk claims by
limiting coverage to such categories of people. Also, the insurance company can choose to
raise the premium commensurately with the level of risk exposure as a way of compensating
the company for the risk of covering high-risk policyholders.

How Does Adverse Selection Work?

Adverse selection occurs when one party in a transaction possesses more accurate
information compared to the other party. The other party with less accurate information is
usually at a disadvantage since the party with more information stands to gain more from that
transaction.

The information imbalance causes inefficiency in the price charged on specific goods or
services. Such scenarios may occur in the insurance sector, capital markets, and even in the
ordinary marketplaces.
Practical Example: Adverse Selection in Life Insurance

To illustrate the concept of adverse selection, we can take the examples of two potential
policyholders who want to take up a life insurance policy with Company ABC. The first
person is diabetic and does not exercise, while the second person has no known illness and is
a fitness enthusiast who exercises several times each week.

A diabetic person has a shorter life expectancy compared to a healthy person, and failure to
exercise regularly increases the risk. Unless the insurance company has information on the
health status of the two potential policyholders, the company will be at a disadvantage and
will treat the patients as ordinary policyholders.

During the onboarding process for new policyholders, the insurance company will ask the
policyholders to fill up registration forms. The company requires potential clients to be
truthful and disclose all relevant information, including health conditions that they are
suffering from. Since the diabetic person is aware that disclosing his condition will attract
high premiums, he will conceal the information in order to get similar treatment as the other
client with no health condition.

Concealing such vital information leads to adverse selection, and the insurance company will
be at a disadvantage since it will enter into an agreement with a diabetic patient without
knowing the health condition that the policyholder has.

Adverse Selection between Buyer and Seller

Adverse selection may occur when a buyer intends to purchase a product or service from a
seller, but the seller has more information about the product. Such a situation places the buyer
at a disadvantage since they are entering into an agreement with a seller who may not
willingly disclose all the information about the product being sold.

For example, when a buyer is looking for a second-hand car to buy, and a seller offers to sell
a car with hidden defects, the buyer will be at a disadvantage unless the seller informs the
buyer about the defect. Adverse selection occurs when the buyer purchases the car without
the seller disclosing the defects that the vehicle has.

Adverse Selection in the Capital Markets

In the capital markets, some securities are more prone to adverse selection than others. For
example, a high growth company may offer equity to investors in the capital markets at a
high price to entice potential investors. Assuming that the managers at the capital markets
have inside information about the company that outside investors are unaware off, then it
subjects the investor to adverse selection.

For example, the managers may be aware of an internal assessment of the company’s current
value that shows that the company’s offer price exceeds the private assessment of the
company. Investors will be at a disadvantage because they will purchase the company’s stock
without knowing that the company is overvalued. If the managers inform the investors about
the overvaluation of the company and the investors proceed to buy the stock, there will no
longer be a state of adverse selection.

Solution to Adverse Selection

One of the ways that insurance companies can avoid adverse selection is by grouping high-
risk individuals and charging them higher premiums. For example, insurance companies
should charge different premium rates to clients depending on the age, health condition,
postcode, weight, medical history, family medical history, hobbies, lifestyle risk (obesity,
smoking, and diabetes), driving record and occupation.

The abovementioned factors impact a person’s health and life expectancy and can determine
the company’s potential to pay a claim. During underwriting, the company should determine
whether to give a potential client an insurance policy and calculate the premium to charge the
specific client.

Additional Resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst
(FMVA)™ certification program, designed to help anyone become a world-class financial
analyst. To keep advancing your career, the additional resources below will be useful:

 Asymmetric Information
 Moral Hazard
 Mosaic Theory
 Principal-Agent Problem