Adverse Selection

Adverse selection is a specific form of the lemons problem: the informed party exploits their information advantage before a contract is signed. The term “adverse” captures the idea that the people most eager to transact are precisely those the other side least wants to deal with. Sick people rush to buy health insurance; risky borrowers seek loans; owners of bad cars are keen to sell.

In insurance markets, adverse selection is devastating. If an insurer charges a premium based on average risk, low-risk individuals (who know they are healthy) find the premium too expensive and drop out. The remaining pool is sicker on average, so the insurer must raise premiums. This triggers a death spiral: higher premiums cause more healthy people to leave, further raising premiums. Solutions include: (1) mandating universal coverage (e.g., the ACA individual mandate), (2) equalizing information through medical exams, and (3) restricting opportunism through waiting periods.

The worked example above had two groups — healthy and unhealthy. Real insurance pools have a whole spread of risk levels. The widget below shows ten customers, lined up from lowest expected cost (customer 1 at 1,000 dollars a year) to highest (customer 10 at 10,000 dollars). Each bar’s height is that customer’s expected medical cost — what the insurer would pay out for them on average. We’ll assume each person is only willing to buy insurance if the premium is less than their own expected cost (otherwise they’re paying more than they expect to get back).

The left panel shows the pool this round — green bars are still in, faded bars with a red ✕ have dropped out. The dashed red line is the premium, set to the average cost of whoever’s left. The right panel tracks the premium across rounds so you can see the spiral climb. Click Round 1 → 2 → 3 → Collapse and watch: each round the cheapest customers exit, the average cost of the leftovers rises, the premium follows, and the next-cheapest group exits. By round 4 nobody is willing to buy at the going price.