The presence of adverse selection in a project, process, or negotiation can often be hard to spot. In this article, we'll define adverse selection and give some examples of how detrimental it can be.
What is Adverse Selection?
Adverse selection is a concept that should be considered when developing any risk management plan. Although most commonly associated with insurance, it can creep into many projects and processes. But what is adverse selection and how can you deal with it?
Adverse selection refers to an event in which one party in a negotiation has relevant information about the situation that the other party lacks. The term “negotiation” can mean many things as used here, but it is often used to refer to the exchange of goods and services with the buyer and the seller being the two parties described in the definition. To better illustrate this concept, we’ll look at a couple of examples.
The Insurance Example
By far, the most common example used to illustrate adverse selection is in the insurance industry. In an ideal world, everyone who wanted to purchase insurance would carry the same risk of actually making a claim on the policy. That is, the seller and the buyer would both benefit from all transactions – the insurance company by assigning the right price to the policy and the insurance buyer by paying the appropriate amount for the policy.
In the real world, this is definitely not the case. Instead, the insurer would prefer to sell insurance to those customers who are least likely to make claims and, thus, “use” the insurance. Buyers, on the other hand, are generally more eager to purchase a policy if they believe they will have a need to make a claim.
The Independent Contractor Example
Adverse selection can also be seen in some scenarios involving the hiring of independent contractors to perform certain types of work. For example, suppose that a landlord owns a number of rental properties and wants to hire someone to mow the lawns and do general yard maintenance for the properties. In this case, further assume that the landlord has decided on a predetermined amount that he is willing to pay per property for this work, and this amount is well below current market value.
The landlord advertises the job and it is accepted by a contractor with very little discussion on exactly what work should be performed. The landlord is expecting a very high quality job to be done, and each yard to be meticulously cared for. Based on the payment being offered, however, the contractor assumes that the landlord only wants minimal yard work done and only provides basic service.
Read on to the next page to find out more about the dangers associated with adverse selection.