Adverse selection

Adverse selection or anti-selection is a term used in economics and insurance.

It was originally used in insurance to describe a situation where the people who take out insurance are more likely to make a claim than the population of people used by the insurer to set their rates. For example, when setting rates for a life insurance contract, a life insurer may look at death rates among people of a certain age in a certain area. Now suppose that there are two groups among the population, smokers and non smokers, and the insurer can't tell which is which so they each pay the same premiums. Non smokers know that they are less likely to die than average and that they are cross subsidising smokers, so will be reluctant to insure themselves, while smokers will have a higher likelihood of claiming so will be more likely to buy insurance. The insurance company ends up with people with higher average mortality rates than allowed for when setting premiums.

In the usual case, a key condition for there to be adverse selection is an asymmetry of information - people buying insurance know whether they are smokers or not, whereas the insurance company doesn't. If the insurance company knew who smokes and who doesn't, it could set rates differently for each group and there would be no adverse selection. However, other conditions may produce adverse selection even when there is no asymmetry of information. For example, some states require health insurance providers to insure all who apply at the same cost. In this case, there may not be an actual asymmetry of information, the insurance company may know who is or isn't a smoker, but the insurer not being allowed to act on that information, there is a "virtual" asymmetry of information.

The concept of adverse selection has been generalised by economists into markets other than insurance, where similar asymmetries of information may exist. For example, George Akerlof developed the model of the "market for lemons." People buying used cars do not know whether they are "lemons" (bad cars) or "cherries" (good ones). The sellers, on the other hand, have this knowledge. At any given price, the sellers will be more likely to sell lemons than cherries, keeping the good cars for themselves. Thus, the buyers will learn to presume that all or most used cars are lemons. This depresses the price of used cars, so that even more of the cherries are held off the market. The "price mechanism" fails to keep the lemons off the market, even in a competitive market. Instead, they dominate the market. Guarantees are needed.

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