What is Adverse selection?
Adverse selection occurs when one party in a transaction has more information than the other, causing the less-informed party to attract disproportionately high-risk counterparts. George Akerlof described the classic example in his 1970 ‘Market for Lemons’ paper.
How it works
In insurance markets, people who know they are high-risk are more likely to buy coverage, while low-risk individuals opt out. This drives up premiums, which pushes even more low-risk people away, creating a downward spiral of coverage quality.
Applied example
A health insurance company that offers the same premium to all applicants may find that mostly people with expensive pre-existing conditions sign up, making the plan unsustainable without risk adjustment or mandates.
Why it matters
Understanding adverse selection explains why markets sometimes fail and why mechanisms like mandatory coverage, screening, and signaling exist to counteract information asymmetries.
