Adverse selection

By:

James Knight

James is a lead editor for Invezz, where he covers topics from across the financial world, from the stock… read more.

Updated: Aug 20, 2021

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The tendency for a contract to attract the types of agent that are least profitable for the issuer. For example, if an insurer offers *health insurance without any medical examination, the expectation is that people with poor health prospects are likely to accept it, while people with better health prospects, who can get better terms from a more selective insurer, will reject the unconditional contract. In trying to be non-selective, adverse selection causes the worst risks to select themselves. Adverse selection is a consequence of asymmetric information: agents know their own type (private information) but this is unobservable (not public information). Contracts that could be offered if agent types were observable cannot be offered when types are unobservable, so adverse selection can lead to ‘market failure.

Reference: Oxford Press Dictonary of Economics, 5th edt.