Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, risk management, and statistics. It refers to a market process in which undesired results occur when buyers and sellers have asymmetric information (access to different information); the "bad" customers are more likely to apply for the service. For example, a bank that sets one price for all of its checking account (current account) customers runs the risk of being adversely selected against by its low-balance, high-activity (and hence least profitable) customers. Two ways to model adverse selection are to employ signaling games and screening games.
The term "adverse selection" was originally used in insurance. It describes a situation where an individual's demand for insurance (the propensity to buy insurance and the quantity purchased) is positively correlated with the individual's risk of loss (higher risks buy more insurance), and the insurer cannot allow for this additional risk in the price of the insurance. This may be because of private information known only to the individual (information asymmetry), or because of regulations, social norms or marketing considerations which prevent the insurer from using certain categories of known information to set prices (for example, the insurer may be prohibited from using such information as gender, ethnic origin, genetic test results, or pre-existing medical conditions). This is sometimes referred to as "regulatory adverse selection".
This can be illustrated by the link between smoking status and mortality. Non-smokers, on average, live longer than smokers. If a life insurance company does not vary prices according to smoking status, its life insurance will be a better buy for smokers than for non-smokers. So smokers may be more likely to buy insurance from that company, or may tend to buy larger amounts than non-smokers, thereby raising the average mortality of the combined policyholder group above that of the insured population in general, and leading to losses for the company and/or higher prices for all that company's customers.
Furthermore, these higher prices may lead the "good risks" (healthy, non-smoking customers) to cancel or not renew their insurance. This promotes a further increase in price: a vicious circle, which might, in theory, lead to the collapse of the insurance market.
To counter the effects of adverse selection, insurers (as far as laws permit and it is economic to do so) ask a range of questions and may request medical or other reports on individuals who apply to buy insurance, so that the price quoted can be varied accordingly, and any unreasonably high or unpredictable risks rejected altogether. This risk selection process is known as underwriting. In many countries, insurance law incorporates an "utmost good faith" or uberrima fides doctrine, which requires potential customers to answer any underwriting questions asked by the insurer fully and honestly; if they fail to do this, the insurer may later refuse to pay claims.
While adverse selection in theory seems an obvious and inevitable consequence of economic incentives, empirical evidence is mixed. Several studies investigating correlations between risk and insurance purchase have failed to show the predicted positive correlation for life insurance, auto insurance, and health insurance. On the other hand, "positive" test results for adverse selection have been reported in health insurance, long-term care insurance, and annuity markets. These "positive" results tend to be based on demonstrating more subtle relationships between risk and purchasing behavior (such as between mortality and whether the customer chooses a life annuity which is fixed or inflation-linked), rather than simple correlations of risk and quantity purchased.
One reason why adverse selection might be muted in practice could be that insurers' underwriting is largely effective. Another possible reason is the negative correlation between risk aversion (such as the willingness to purchase insurance) and risk level (estimated ex ante based on observation of the ex post occurrence rate of observed claims) in the population: if risk aversion is higher among lower risk customers, such that persons less likely to engage in risk-increasing behavior are more likely to engage in risk-decreasing behavior (to take affirmative steps to reduce risk), adverse selection can be reduced or even reversed, leading to "propitious" or "advantageous" selection.
For example, there is evidence that smokers are more willing to do risky jobs than non-smokers, and this greater willingness to accept risk might reduce insurance purchase by smokers. From a public policy viewpoint, some adverse selection can also be advantageous because it may lead to a higher fraction of total losses for the whole population being covered by insurance than if there were no adverse selection.
In studies of health insurance, an individual mandate that requires people to either purchase plans or face a penalty is cited as a way out of the adverse selection problem by broadening the risk pool. Mandates, like all insurance, increase moral hazard.
- Agency cost
- Contract theory
- Community rating
- Death spiral (insurance)
- Information asymmetry
- Market for lemons
- Moral hazard
- Principal–agent problem
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