Selective trading based on possession of hidden information
In economics, insurance, and risk management, adverse selection is a market situation where asymmetric information results in a party taking advantage of undisclosed information to benefit more from a contract or trade.
In an ideal world, buyers should pay a price which reflects their willingness to pay and the value to them of the product or service, and sellers should sell at a price which reflects the quality of their goods and services. However, when one party holds information that the other party does not have, they have the opportunity to damage the other party by maximizing self-utility, concealing relevant information, and perhaps even lying. This opportunity has secondary effects: the party without the information may take steps to avoid entering into an unfair contract, perhaps by withdrawing from the interaction; a party may ask for higher or lower prices, diminishing the volume of trade in the market; or parties may be deterred from participating in the market, leading to less competition and higher profit margins for participants.
A standard example is the market for used cars with hidden flaws, also known as lemons. George Akerlof in his 1970 paper, "The Market for 'Lemons'", highlights the effect adverse selection has on the used car market, creating an imbalance between the sellers and the buyers that may lead to a market collapse. The paper further describes the effects of adverse selection in insurance as an example of the effect of information asymmetry on markets, a sort of "generalized Gresham's law".
The theory behind market collapse starts with consumers who want to buy goods from an unfamiliar market. Sellers, who have information about which good is high or poor quality, would aim to sell the poor quality goods at the same price as better goods, leading to a larger profit margin. The high quality sellers now no longer reap the full benefits of having superior goods, because poor quality goods pull the average price down to one which is no longer profitable for the sale of high quality goods. High quality sellers thus leave the market, thus reducing the quality and price of goods even further. This market collapse is then caused by demand not rising in response to a fall in price, and the lower overall quality of market provisions. Sometimes the seller is the uninformed party instead, when consumers with undisclosed attributes purchase goods or contracts that are priced for other demographics.
Adverse selection has been discussed for life insurance since the 1860s, and the phrase has been used since the 1870s.
Examples.
Insurance.
Adverse selection was first described for life insurance. It creates a demand for insurance which is positively correlated with the insured's risk of loss.
For example, overall, non-smokers have a much lower risk of death than smokers of the same age and sex. If the price of insurance does not vary according to smoking status, then it will be more valuable for smokers than for non-smokers. Thus smokers will have a greater incentive to buy insurance and will purchase more insurance than non-smokers. This increases the average mortality rate of the insured pool, causing the insurer to pay more claims. The insurer relies on the premiums of the healthy non-smokers to cover the costs incurred by the smokers. As more smokers purchase insurance, costs to insure them increases.
In response, the company may increase premiums to correspond to the higher average risk. However, higher prices cause rational non-smokers to cancel their insurance as insurance becomes uneconomic for them, exacerbating the adverse selection problem. Eventually, higher prices will push out all non-smokers in search of better options, and the only people left who will be willing to purchase insurance are smokers. The same applies to health insurance.
To counter the effects of adverse selection, insurers may require premiums that reflect the customer's risk, distinguishing high-risk from low-risk individuals. For instance, medical insurance companies ask a range of questions and may request medical or other reports on individuals who apply to buy insurance. The premium can be varied accordingly, and any unacceptably high-risk individuals are rejected ("cf." pre-existing condition). This risk selection process is part of underwriting. In many countries, insurance law incorporates an "utmost good faith" or "uberrima fides" doctrine, which requires potential customers to answer any questions asked by the insurer fully and honestly. Dishonesty may be met with refusals to pay claims.
Adverse selection can also result from government regulations prohibiting insurers from setting prices based on certain information. This is sometimes referred to as "regulatory adverse selection". For instance, the US government enacted the Affordable Care Act (ACA) which prohibits insurers from charging higher prices based on pre-existing conditions and gender. To help prevent adverse selection, the ACA was designed with a risk adjustment programme to compensate insurers with sicker enrollees. The ACA also required US residents to enroll in healthcare coverage or pay a tax penalty. This was in place to ensure enrollment by healthy individuals, even though they are less likely to claim and thus they may not otherwise have considered the coverage to be financially worthwhile.
Empirical evidence of adverse selection 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.
Weak evidence of adverse selection in certain markets suggests that the underwriting process is effective at screening high-risk individuals. Another possible reason is the negative correlation between risk aversion (such as the willingness to purchase insurance) and risk level (estimated beforehand based on hindsight observation of the occurrence rate for other observed claims) in the population. If risk aversion is higher among lower-risk customers, adverse selection can be reduced or even reversed, leading to "advantageous" selection. This occurs when a person is both less likely to engage in risk-increasing behaviour are more likely to engage in risk-decreasing behaviour, such as taking affirmative steps to reduce risk.
For example, there is evidence that smokers are more willing to do risky jobs than non-smokers. This greater willingness to accept risk may reduce insurance policy purchases by smokers.
From a public policy viewpoint, some adverse selection can also be advantageous. Adverse selection may lead to a higher fraction of total losses for the whole population being covered by insurance than if there were no adverse selection.
Capital markets.
When raising capital, some types of securities are more prone to adverse selection than others. An equity offering for a company that reliably generates earnings at a good price will be bought up before an unknown company's offering, leaving the market filled with less desirable offerings that were unwanted by other investors. Assuming that managers have inside information about the firm, outsiders are most prone to adverse selection in equity offers. This is because managers may offer stock when they know the offer price exceeds their private assessments of the company's value. Outside investors, therefore, require a high rate of return on equity to compensate them for the risk of buying a "lemon".
Adverse selection costs are lower for debt offerings. When debt is offered, this acts as a signal to outside investors that the firm's management believes the current stock price is undervalued, as the firm would otherwise be keen on offering equity.
Thus the required returns on debt and equity are related to perceived adverse selection costs, implying that debt should be cheaper than equity as a source of external capital, forming a "pecking order".
The example described assumes that the market does not know managers are selling stock. The market could gain access to this information, perhaps by finding it in company reports. In this case, the market will capitalize on the information found. If the market has access to the company's information, the presence of information asymmetry is removed, and as such there is no longer a state of adverse selection.
The presence of adverse selection in capital markets results in excessive private investment. Projects that otherwise would not have received investments due to having a lower expected return than the opportunity cost of capital, received funding as a result of information asymmetry in the market. As such, governments must account for the presence of adverse selection in the implementation of public policies.
Contract theory.
In modern contract theory, "adverse selection" characterizes principal-agent models in which an agent has private information "before" a contract is written. For example, a worker may know his effort costs (or a buyer may know his willingness-to-pay) "before" an employer (or a seller) makes a contract offer. In contrast, "moral hazard" characterizes principal-agent models where there is symmetric information at the time of contracting. The agent may become privately informed "after" the contract is written. According to Hart and Holmström (1987), moral hazard models are further subdivided into hidden action and hidden information models, depending on whether the agent becomes privately informed due to an unobservable action that he himself chooses or due to a random move by nature. Hence, the difference between an adverse selection model and a hidden information (sometimes called hidden knowledge) model is simply the timing. In the former case, the agent is informed at the outset. In the latter case, he becomes privately informed after the contract has been signed.
In most adverse selection models, it is assumed that the agent's private information is "soft" (i.e., the information cannot be certified). Yet, there are also some adverse selection models with "hard" information (i.e., the agent may have evidence to prove that claims he makes about his type are true).
Adverse selection models can be further categorized into models with private values and models with interdependent or common values. In models with private values, the agent's type has a direct influence on his own preferences. For example, he has knowledge over his effort costs or his willingness-to-pay. Alternatively, models with interdependent or common values occur when the agent's type has a direct influence on the principal's preferences. For instance, the agent may be a seller who privately knows the quality of a car.
Seminal contributions to private value models have been made by Roger Myerson and Eric Maskin, while interdependent or common value models have first been studied by George Akerlof. Adverse selection models with private values can also be further categorized by distinguishing between models with one-sided private information and two-sided private information. The most prominent result in the latter case is the Myerson-Satterthwaite theorem. More recently, contract-theoretic adverse selection models have been tested both in laboratory experiments and in the field.
Banking.
When banks and borrowers come together to determine the personal loans, mortgages or business loans, adverse selection is deeply rooted in the discussions.
For example, when a new customer approaches a bank seeking a personal loan, they will always know their spending, saving and potential income better than the bank would. This creates adverse selection as the customer possess information about their life which is unknown to the bank, and they can take an economic advantage due to this information.
Similarly, when a business requests a loan from a bank, this also creates adverse selection. The business possesses information about market trends, insider business knowledge, and other future happenings relevant to the business that a bank would not know when lending money to a company. 
A further case where adverse selection is relevant is when banks trade loans. This process creates adverse selection, as when a bank transfers a loan to a new bank, they are unaware of how risky the borrower is and the other associated risks that go along with banks lending their money.
To counteract the effects of adverse selection, banks have moved towards building stronger relationships with their customers, to assist in further understanding some of the hidden information the consumers have when they are borrowing from banks. Furthermore, banks can adjust interest rates to help alleviate some of they unknown risks involved. Banks have also implemented heavier screening on loan applicants so that they are receiving the full picture when they lend their money to borrowers. They are investing significant amounts of resources to gather enough information on borrowers to help estimate the possibility of the loan being repaid by the borrower. Additionally, banks have implemented limits on lending for some borrowers to lower the risk of customers defaulting on their loan.
Banks have been trying to