Understanding Adverse Selection

What Is Adverse Selection?

Adverse selection happens when one person in a deal knows more important information than the other. This usually leads to one side making a better decision for themselves at the expense of the other.

Example 1: Understanding Adverse Selection

Imagine you're trading cards. If you know one of your cards is rare but the person you're trading with doesn't, you have an advantage because of your extra knowledge. This situation in business and insurance is called adverse selection.

Adverse selection occurs when one person in a deal knows something important that the other doesn't. This often leads to one side benefiting at the expense of the other.

Example 2: Buying a Used Car

Imagine buying a used car that the seller knows has hidden problems. If you buy it without knowing these issues, you might pay too much and face unexpected repairs. The seller benefits from selling at a higher price, despite knowing the car's faults.

Adverse Selection in Insurance

In insurance, people who are more likely to need coverage are the ones who tend to buy it. For example, someone with a dangerous job might buy more life insurance. Insurance companies adjust by charging higher premiums to those at greater risk, like charging more for smokers or people with hazardous jobs.