What is meant by adverse selection?

Adverse selection refers to a situation in financial markets where one party to a transaction possesses asymmetric information that the other party lacks, leading to inefficient or undesirable outcomes. This occurs when high-risk borrowers or policyholders are more likely to seek financial services (e.g., loans, insurance) than low-risk individuals, as they benefit more from such arrangements.

For example, in credit markets, lenders cannot perfectly assess the creditworthiness of borrowers. As a result, only risky borrowers (who are more likely to default) apply for loans, increasing the lender’s risk exposure. Similarly, in insurance markets, individuals with higher-than-average risk (e.g., poor health) are more inclined to purchase insurance, driving up premiums for all policyholders.

Adverse selection distorts market efficiency and increases transaction costs, necessitating mechanisms like screening, signaling, or regulatory oversight to mitigate its effects.