Adverse selection is a concept in economics and insurance that describes a situation where there is a presence of information asymmetry between buyers and sellers which leads to the market being dominated by “bad” products or high-risk individuals. It occurs when one party in a transaction has more or better information than the other, often resulting in a market where goods or services of lower quality are more likely to be selected.
Imagine you are buying a used car, but you can’t tell which ones are in good condition and which ones are in bad condition. Sellers know if their car is good or bad but you don’t, so there’s a chance you’ll end up buying a bad car. Because of this risk, good cars might be driven out of the market, leaving more bad ones for sale. This problem of ending up with a bad selection, because you didn’t have enough information, is called adverse selection.
Adverse selection is particularly relevant in the fields of insurance and finance. In insurance, it refers to the tendency for higher-risk individuals to be more likely to purchase insurance because they anticipate higher usage, while lower-risk individuals opt out. This can lead to a pool of insured individuals that is riskier than the general population, potentially causing premiums to rise and even leading to market failure. For example, in health insurance, if only those who expect to have high medical costs buy insurance, the insurance pool can become unsustainable due to the high cost of claims. n the job market, adverse selection can occur if employers cannot differentiate between high-skilled and low-skilled workers, potentially leading to underemployment of highly skilled workers.
Source: A to Z of Economics by Dr. NC Raghavi Chakravarthy