What Is Adverse Selection? (With Examples and Tips)
By Indeed Editorial Team
Published 31 May 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
All markets experience adverse selections, also known as asymmetric information or anti-selection. This occurs due to an imbalance of knowledge between you and a professional offering a service or product and most often happens in instances dealing with a purchase, such as insurance. In this article, we explain what adverse selection is, tell you what the risks are and how to minimise them with examples.
What is adverse selection?
Adverse selection is a term most often used to describe a situation where someone has a deeper knowledge base about a service or product than you do. When this occurs during negotiations for a financial transaction to occur, a person with more information about the quality of a product or service involved has an unfair advantage. This creates an unequal business exchange between the buyer and the seller. As a result, one person might experience a financial loss and the other person an excessive financial gain from the sale.
The risk of experiencing a monetary loss due to anti-selection can decrease when you're a regular, repeat client. Ideally, both parties involved in a transaction demonstrate equal knowledge of the information. This can lead to you making the best decision about a transaction.
4 examples of anti-selection
Here's a list of four examples demonstrating how anti-selection can occur in business transactions:
1. Life, health and disability insurance
Life, health and disability insurance are some of the common professional contracts that experience high rates of asymmetric information. In this scenario, anti-selection can occur when purchasing insurance from an insurance broker. For example, when a client deliberately doesn't reveal their existing health issues on the insurance application form, this may result in the insurance company suffering a financial loss due to a future insurance claim made for an undisclosed health condition.
Some insurance purchasers hide their existing medical conditions so that they can pay a low insurance premium. Once the insurance agreement is signed, the purchasing client is then able to maximise their financial return at a later date with a claim. Prior to the time of signing the agreement, the insurance seller is unaware of the purchaser's existing medical problems. The client then receives payment for the medical condition they knew they had, but the insurance seller was unaware of.
2. Used car sales
Used car sales are another common industry where anti-selection occurs. This can create a disadvantage for potential vehicle buyers when a salesperson knows about hidden mechanical issues in a car but fails to reveal them to a customer. As a result, once a customer purchases the vehicle, the car might break down, causing them to experience additional repair costs.
This might result in a financial gain for the used car salesperson, as they may make a higher profit than the car is worth. There may be a financial loss for the new car owner, who assumed the car was in prime condition and of higher quality. In reality, the car is not worth the money it's purchased for.
3. Real estate
Real estate is a long-term investment with risks that increase when there's a failure for the real estate seller to be transparent about any issues with the property. For instance, a real estate agent may know that a particular area has a high crime rate. The agent may give a false impression to the buyer that the risk of theft is low in the area. Once the client completes the transaction for the property, they may begin to suffer a financial loss due to crime.
4. Capital markets
Capital markets involve buyers and sellers trading long-term financial securities. Most often, these companies may show a return on an investment after a few years. When managers of capital markets have the advantage of inside information about a potential transaction and potential investors don't, they may experience adverse selections. Examples of long-term securities include:
insured savings accounts
high-yield savings accounts
alternative investments in commodities, such as cryptocurrency
What are the consequences of adverse selections?
It's important to understand what the consequences of adverse selections are to ensure you have adequate knowledge when making purchases. Ideally, a business deal works best when both a seller and their client share an equal amount of knowledge about a service and contract agreement. When there isn't an equal amount of information shared in a business deal, there's a potential consequence of loss to one of the party's involved in the business transaction. The loss may then extend and affect the entire industry it occurs in. These consequences may include, but aren't limited to, the following:
continued selling of faulty products by a business
continued processing of insurance claims for financial gain by consumers
current clients experiencing increased costs
current clients deciding to discontinue business due to increasing costs
potential market price and rate increases
fewer market options
Ways to minimise the risk of adverse selections
The best way to minimise and eliminate the risk of adverse selection is to establish mutual trust between both parties in a business transaction. It's also good business practice to exchange vital information with each other. Information transparency is key to providing and receiving enough knowledge to base your purchasing decisions on. Here are some ways you can minimise the risks involved with this issue:
Seek the advice of third party professionals
At times, it's important to seek the advice of professionals with expertise in the area of business you want to invest in. This is a good business practice, especially when you're dealing with a professional or industry for the first time. A third party can offer you a second opinion before committing to a business transaction or legally binding agreement. It can bring you peace of mind before you sign a contract.
Do your research
It's important to do your research on the product or service you want to invest your time and money into. Research is a way to study information and material from credible sources on the product you want to invest in. Finding the facts about a product enables you to make better financial decisions about the investments you choose. Certain areas of investment change regularly and through research, you can remain up to date on the latest information.
Demonstrate your trustworthiness
One way to minimise risk is to seek out established and trusted companies and salespeople. Ensure your reputation is also reliable. If you're a professional that others seek, make it a priority to maintain your integrity. Repeat dealings between sellers and buyers, professionals and clients, can drastically minimise and eliminate the risk of experiencing financial and health losses.
Check government regulatory requirements
It's a good practice to check government regulatory requirements and educate yourself on what the mandates are in your particular area of interest in investing. Through attaining education and knowledge of the regulations in the area you're exploring, you can better equip yourself to identify and avoid the risk of financial losses during a transaction.
Check market response to anti-selection
Some businesses take the initiative to provide an in-house market response to address a problem with asymmetric information. It's referred to as a seller-granted warranty on the products a company sells. This creates a business practice where a legal guarantee is available to sellers if a product they purchase proves faulty. Money-back guarantees are also a part of this business practice.
Search for online consumer and competitor monitors
You can search for online consumer and competitor monitors as an effective way to do research on companies and products. There are many consumer reports you can access through search engines to attain these valuable resources. The reports aid in minimising the information gap about products while they monitor products. Specially designed software is also available to track and monitor reviews about brands on social media and official consumer review websites. You simply need to conduct an internet search for the review services and reports.
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