Adverse Selection Guide: How to Reduce Adverse Selection

Adverse selection is a term used to describe an information imbalance between a buyer and seller of a product or service. Adverse selection occurs when a seller or a buyer has more information about a product or service's quality than their counterpart. This creates a dynamic of information asymmetry in which one party can exploit this information for their own self-interest, often at the other party’s expense.

Adverse selection impacts the party with less knowledge about the transaction, leaving them open to losing money or committing to a bad investment because they don't have all the information required to make an informed decision.

For buyers, this may mean purchasing a low-quality product that the seller has misrepresented or omitted information about, meaning the buyer is losing money. For sellers, this can mean offering a service to a customer who hasn’t disclosed important information about themselves that makes them a risky investment.

Adverse selection is a phenomenon commonly seen in the stock market, the product marketplace, and the insurance industry. Here are three examples of adverse selection at work.

1. 1. The stock market. Traders selling shares in the stock market may have more information about their shares than the customer. For instance, a seller may misrepresent a particular stock as more valuable than it is. Perhaps they have information about future plans for a company—that the customer does not know of—which may negatively impact the investment’s share price. This asymmetry of information can be disadvantageous to buyers who may buy shares in the company without knowing that those shares are currently overvalued.
2. 2. Second-hand cars. In the used car market, buyers typically have less information about the car than the seller do. This mismatch of information can allow some car sellers to sell "lemons" (or defective cars) at inflated prices that what they might be worth.
3. 3. Health insurance markets. Insurers that sell health insurance plans or life insurance plans can encounter adverse selection if a potential new customer misrepresents their personal history. Providing insurance coverage to high-risk individuals with undisclosed medical conditions can be far more costly for health insurers than covering healthy individuals. Health insurance companies will mitigate this risk by requesting health records or by working with underwriters, who will look into relevant information regarding an applicant’s health status and history.

Reducing adverse selection can mean reducing the risk of losing money for the party with less information. Here are some general ways that buyers and sellers can reduce their risks of being affected by adverse selection.

• For sellers: Sellers (such as banks providing loans or health insurance companies) typically mitigate the risk of taking on a risky customer by screening borrowers or buyers for their eligibility for a certain product or service. Insurance policy sellers can implement an underwriting process to screen potential buyers for previous medical histories, while banks and money lenders screen customers via their credit history.
• For buyers: Buyers that want to reduce adverse selection can research the companies they plan to buy from, consult third-party ratings, and compare the average price and quality of products and services with competing companies. Competitive markets work in the favor of buyers when reducing adverse selection.

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