Adverse selection describes circumstances in which either buyers or sellers have information that the other group does not have. In these cases, when these two groups are informed to different degrees, this is known as asymmetric information.
Naturally, the result is that one party has a consistent advantage over the other, which leads to inefficiency in the price of goods/services within the market. It leads to ill-informed, poor decisions on the part of either buyers or sellers.
Adverse Selection in the Insurance Industry
The term adverse selection is often used in the insurance industry. People with high-risk lifestyles (smokers, people employed in dangerous jobs, etc.) are more likely to seek out life insurance, as they and their families are more likely to financially benefit from it.
Insurance companies respond to this trend and reduce adverse selection by setting up significant limitations on coverage, or else by raising the cost of premiums quite high for high-risk policyholders.
Health insurance companies charge smokers more than non-smokers; car insurance companies charge new drivers (who are more likely to get into accidents) significantly more than experienced drivers; and life insurance companies charge those in dangerous jobs (e.g. logging, commercial fishing) higher premiums.
Without these targeted price increases, adverse selection can instead lead to prices increasing overall. This is because companies will otherwise respond to the financial threat of adverse selection by raising prices across the board. This is done to account for losses from high-risk insurance policyholders. The result, though, is that lower-risk policyholders will choose not to invest in insurance.
Adverse Selection in the Marketplace
The adverse selection problem is by no means unique to the world of insurance. If sellers in any industry have more information than buyers, the latter is automatically disadvantaged, and are likely to be overcharged.
One example is in the marketplace is that of used car sales. A car dealership might be aware that a car they are selling has a major flaw, one that is not immediately apparent to buyers. The dealership may fail to divulge this information and sell the car for more than it is worth; the buyer is effectively swindled.
Moral Hazard vs. Adverse Selection
Adverse selection happens when one side of a deal has more information than the other—when there is a state of asymmetric information, as described above.
In contrast, moral hazard is when one side provides misleading information and, when protected from risk, is freed up to behave more recklessly than they would without this protection. People are incentivized to take risks in situations when other parties will be forced to take on the costs of those risks. For example, homeowners may be less careful once they have theft insurance, because they are financially covered in case of a robbery. This term is most commonly used in the insurance industry but is relevant to finance as well.
The two concepts are related—both involve asymmetric information. In practice, the most notable difference between the two terms is that adverse selection is focused on informational asymmetry before a deal goes through, while moral hazard is concerned with informational asymmetry following the deal.