Explain the problem of adverse selection. How might this problem affect transactions in the insurance industry?

Question

Please provide the best answer for the statement.

Answer 1

The adverse selection problem is an information problem that arises between buyer and seller. Buyers of a product who have the largest potential to benefit or to impose costs on a seller are also the ones most likely to enter into a contract with a seller, although the seller does not know this information ahead of time. In insurance purchases, for example, the people most likely to receive a payout from insurance are the very ones most likely to purchase insurance, but information about high-risk buyers is not known ahead of time by the seller. This adverse selection problem may result in losses that reduce the number of sellers in a private insurance market. Government intervention may be necessary to require social insurance so that a larger pool of people, rather than those most likely to benefit, purchase the insurance.