Adverse Selection

Adverse Selection is a term used in the insurance industry for a particular kind of market breakdown. The breakdown proceeds in a cycle where the distribution of customers shifts toward higher and higher risk buyers while the insurance company keeps raising prices to compensate until the only buyers who buy are truely horrible risks.

In all markets buyers and sellers have differing amounts of information about the goods being exchanged. For traditional manufactured goods sellers tend to know a lot about the costs of production while buyers tend to be better informed about the benefits they can capture after purchase. I.e. buyers tend to know more about the future and sellers more about the past.

Transactions are more likely to take place in the presense of these information asymmetries. If the buyer and seller have different models of worth then after the transaction has closed both parties can be happy with the outcome. If they have identical models then the best they can do is close the transaction with both parties meerly satisfied that they didn’t get taken. To an optimist this means that markets make everybody happier; to a pessimist it means that any transaction leaves money on the table.

The adverse selection senario given above is interesting because both buyer and seller are attempting to predict the future. A successful insurance company manages, thru the magic of statistics, to gain an upper hand in the information in balance.

One of the definitions linked to above gives this very concise definition of adverse selection: “A situation in which market participation is a negative signal.” Anytime a buyer or seller enter a market and begin to participate they reveal some information about the hand they have been dealt. When a market begins to fall apart via the process of adverse selection the market becomes structurally flawed so that only customers who are truely lousy risks will still enter the market. Once this happens then entering the market tends to signal that your a lousy customer.

Market structure creates selections pressures on both the buyers and the sellers. A market maker strives to maintain markets were these selection presures don’t drive the market in any of many the wrong directions. So while a “adverse selection” is a term used in the insurance industry it certainly would seem to be equally applicable to any number of other markets and in all cases it would seem to apply to both buyers and sellers. If the market is poorly structured then as tranactions clear the buyers and the sellers are both happy; but as the future unfolds one or both of them become unhappy.

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