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LEGAL DICTIONARY

Adverse Selection

What Is Adverse Selection?

Adverse selection (also called anti-selection or asymmetric information) is the term for when one party has more or better information about a product or service than the other party involved in a transaction. The more informed party can then use that knowledge at the expense of the other party in signing legal contracts.

Adverse selection can give a buyer or seller an advantage in markets such as the insurance, financial, real estate, and automobile markets.

What Are Examples of Adverse Selection?

Adverse selection can occur in contracts in many industries and marketplaces. Here are a few typical adverse selection examples.

Adverse selection in real estate

An example of adverse selection in the real estate industry would be if the seller’s real estate agent knows the seller has covered up evidence of mold and water damage to the home with paints and boards but does not disclose this information to a buyer.

The buyer’s inspector does not find the damage, and the buyer makes a successful bid on the home without knowing the damage and the trouble that could be ahead for the home.

Draft Your Lead Based Paint Disclosure Form

Adverse selection in insurance

An individual with pre-existing health conditions and other risk factors does not disclose that information when applying for health insurance coverage.

Without that information, the insurance provider offers the individual coverage at the same price as a healthy person. In this example, the insurance buyer benefits, and the insurance company is at a disadvantage.

Adverse selection in used cars

In this example, the seller of a used car withholds information about the vehicle’s engine troubles in highway driving. Both in ads and in person, the seller presents this “lemon car” as in good condition and prices it accordingly. The problem does not show up in a short test drive, and the buyer purchases the vehicle based on the seller’s information.

Get Your Free Letter of Intent Template

What Are the Consequences of Adverse Selection?

In each of the above examples, one party is at a distinct disadvantage over the other party. In other words, one party is paying more or receiving less money than the transaction warrants. In some cases, this lack of information can cause more than financial woes; it could lead to other forms of harm in the future.

When adverse selection occurs, it may not only harm one party. For example, an insurance company may have to raise its rates for all policyholders because of losses due to adverse selections. Insurance companies also may be less likely to take on unhealthy clients who do reveal their health history.

How to Lower the Risk of Adverse Selection

Adverse selection can be seen as a moral hazard. A moral hazard is defined as a situation in which one party does not act in good faith because they know the other party will face the consequences of their unscrupulous behavior.

Adverse selection can lead one party to take on unintended risks in a transaction. However, there are some ways buyers and sellers can protect themselves from adverse selection.

  • Read online customer reviews on websites, blogs, and marketplaces.
  • Look for warranties and guarantees on big purchases.
  • Be aware of your legal rights, such as Lemon Laws, that protect buyers on the state and federal levels.
  • Request medical records for potential insurance clients.

Helpful Resources:

Investopedia - Adverse Selection: Definition

Britannica - Adverse Selection

Corporate Finance Institute - Adverse Selection

Indeed.com - What Is Adverse Selection? Definition and Examples

What Is Adverse Selection?

Adverse selection (also called anti-selection or asymmetric information) is the term for when one party has more or better information about a product or service than the other party involved in a transaction. The more informed party can then use that knowledge at the expense of the other party in signing legal contracts.

Adverse selection can give a buyer or seller an advantage in markets such as the insurance, financial, real estate, and automobile markets.

What Are Examples of Adverse Selection?

Adverse selection can occur in contracts in many industries and marketplaces. Here are a few typical adverse selection examples.

Adverse selection in real estate

An example of adverse selection in the real estate industry would be if the seller’s real estate agent knows the seller has covered up evidence of mold and water damage to the home with paints and boards but does not disclose this information to a buyer.

The buyer’s inspector does not find the damage, and the buyer makes a successful bid on the home without knowing the damage and the trouble that could be ahead for the home.

Draft Your Lead Based Paint Disclosure Form

Adverse selection in insurance

An individual with pre-existing health conditions and other risk factors does not disclose that information when applying for health insurance coverage.

Without that information, the insurance provider offers the individual coverage at the same price as a healthy person. In this example, the insurance buyer benefits, and the insurance company is at a disadvantage.

Adverse selection in used cars

In this example, the seller of a used car withholds information about the vehicle’s engine troubles in highway driving. Both in ads and in person, the seller presents this “lemon car” as in good condition and prices it accordingly. The problem does not show up in a short test drive, and the buyer purchases the vehicle based on the seller’s information.

Get Your Free Letter of Intent Template

What Are the Consequences of Adverse Selection?

In each of the above examples, one party is at a distinct disadvantage over the other party. In other words, one party is paying more or receiving less money than the transaction warrants. In some cases, this lack of information can cause more than financial woes; it could lead to other forms of harm in the future.

When adverse selection occurs, it may not only harm one party. For example, an insurance company may have to raise its rates for all policyholders because of losses due to adverse selections. Insurance companies also may be less likely to take on unhealthy clients who do reveal their health history.

How to Lower the Risk of Adverse Selection

Adverse selection can be seen as a moral hazard. A moral hazard is defined as a situation in which one party does not act in good faith because they know the other party will face the consequences of their unscrupulous behavior.

Adverse selection can lead one party to take on unintended risks in a transaction. However, there are some ways buyers and sellers can protect themselves from adverse selection.

  • Read online customer reviews on websites, blogs, and marketplaces.
  • Look for warranties and guarantees on big purchases.
  • Be aware of your legal rights, such as Lemon Laws, that protect buyers on the state and federal levels.
  • Request medical records for potential insurance clients.

Helpful Resources:

Investopedia - Adverse Selection: Definition

Britannica - Adverse Selection

Corporate Finance Institute - Adverse Selection

Indeed.com - What Is Adverse Selection? Definition and Examples