Adverse Selection
When information asymmetry causes lower-quality counterparties to disproportionately participate in a market.
What is Adverse Selection?
Adverse selection is a market phenomenon that occurs when information asymmetry between buyers and sellers causes the lower-quality or higher-risk side to be more likely to participate in a transaction, ultimately degrading average quality and potentially causing market failure. George Akerlof's 1970 'Market for Lemons' paper illustrated the problem using used car markets: sellers know whether their car is a lemon, but buyers do not — so buyers discount all cars to the average, driving quality sellers out and leaving mainly lemons. In insurance, adverse selection occurs when high-risk individuals are more likely to buy coverage, forcing insurers to raise premiums, which drives away lower-risk customers, worsening the pool in a spiral.
Example
In health insurance markets before the Affordable Care Act's individual mandate, adverse selection was a documented problem: healthy individuals often chose not to buy insurance at prevailing prices, leaving a sicker-than-average insured pool that required premium increases. Higher premiums then caused more healthy people to opt out, further worsening the pool — the classic adverse selection 'death spiral' that the mandate was designed to counter.
Source: Kaiser Family Foundation — How the ACA's Individual Mandate Affects Adverse Selection