Adverse Selection: Key Examples and Differences

In the fields of economics, insurance, and finance, two critical concepts often arise in discussions of market failure and risk: moral hazard and adverse selection. While both stem from information asymmetry—where one party in a transaction has more or better information than the other—they describe distinct phenomena with different implications. Understanding their differences through concrete examples is essential for policymakers, insurers, and business leaders.

Understanding the Core Concepts

Adverse Selection occurs *before* a transaction takes place. It is a “hidden information” problem. The party with more information uses it to their advantage, leading to a market where high-risk participants are disproportionately attracted. This can drive out lower-risk participants and cause market inefficiency or collapse.

Moral Hazard occurs *after* a transaction or agreement is in place. It is a “hidden action” problem. Once protected by an agreement (like insurance or a bailout), one party may change their behavior, taking on more risk because they do not bear the full consequences of that risk.

Adverse Selection in Action:

Key Examples

1. The Used Car Market (The “Lemon Problem”):
Made famous by economist George Akerlof, this is the classic example. Sellers of used cars have more information about the vehicle’s true quality than buyers. Sellers of poor-quality cars (“lemons”) are more motivated to sell, while sellers of good cars may withdraw from the market, fearing they won’t get a fair price. This leads to a market flooded with lemons, driving down prices and quality.

2. Health Insurance Markets:
Individuals likely know more about their own health risks (e.g., family history, lifestyle habits) than an insurance company. Those who anticipate high medical costs are the most motivated to buy comprehensive insurance, while healthier individuals may opt out. This leaves the insurer with a riskier pool of customers than expected, forcing premiums up, which in turn drives away more healthy people—a cycle known as a “death spiral.”

3. Credit Markets:
Borrowers know more about their own ability and intention to repay a loan than lenders do. Riskier borrowers, who are more likely to default, will actively seek out loans and may even agree to higher interest rates. Safer borrowers may be discouraged by the high rates, leading banks to be left with a disproportionately risky loan portfolio.

Moral Hazard in Action:

Key Examples

1. Insurance Deductibles and Behavior:
Once a person has comprehensive car insurance with a low deductible, they may become less cautious. They might park in riskier areas or drive more recklessly, knowing the insurer will cover most of the cost of an accident. The insurer bears the consequence of the increased risk. This is why insurers use tools like deductibles and co-pays to ensure the policyholder retains some “skin in the game.”

2. Bank Bailouts and Financial Institutions:
If a large bank believes the government will bail it out in a crisis (“too big to fail”), it has an incentive to engage in riskier investments to chase higher profits. The bank enjoys the gains in good times, while taxpayers bear the losses in bad times. This post-agreement change in risk appetite is a quintessential moral hazard.

3. Corporate Management with Limited Liability:
Company executives, protected by the corporation’s limited liability structure and often rewarded with stock options for short-term gains, might pursue overly aggressive strategies. If the strategy succeeds, they reap large bonuses. If it fails catastrophically, the shareholders and creditors bear the brunt of the losses, not the executives personally.

Side-by-Side Comparison:

The Health Insurance Context

| Scenario | Adverse Selection | Moral Hazard |
| :— | :— | :— |
| Timing | Occurs before signing the insurance contract. | Occurs after the insurance contract is in force. |
| Information Problem | Hidden Information: The applicant knows they have a risky pre-existing condition but doesn’t disclose it. | Hidden Action: The insured person goes to the doctor for every minor ailment because the visit is “free” (covered by insurance). |
| Behavior/Incentive | “I am sick, so I will buy the most extensive plan.” | “I am insured, so I can use more healthcare services than I truly need.” |
| Result for Insurer | Attracts a pool of customers who are sicker than the average population, leading to unexpected losses. | The insured party’s increased utilization of services drives up claims costs. |

Mitigating the Problems

* Combating Adverse Selection: Mechanisms include screening (medical exams, credit checks), signaling (warranties on used cars, educational degrees), and mandatory pooling (requiring everyone to have health insurance, as with the Affordable Care Act’s individual mandate).
* Combating Moral Hazard: Solutions involve incentive alignment (deductibles, co-pays, performance-based pay), monitoring (progressive auto insurance trackers), and contract design that ties rewards to desired outcomes and penalties to risky behavior.

Conclusion

While moral hazard and adverse selection are both born from information gaps, they operate at different stages of an economic relationship and require different remedies. Adverse selection is about the wrong people entering an agreement, polluting the risk pool from the start. Moral hazard is about people changing their behavior once protected, increasing risk after the deal is done. Recognizing which problem is at play is the first step in designing effective contracts, regulations, and policies to create more stable and efficient markets.