Adverse Selection When Buyers Have More Information: The Market for Insurance

Information asymmetry in situations, where buyers have more knowledge than sellers, can lead to adverse selection, as seen in the market for insurance.

For instance, buyers purchasing a life insurance policy typically have more knowledge about their own health and job risks than the companies selling the policy. 

Imagine a logging worker, Sarah, who harvests timber from forests. She often works in harsh weather conditions and at remote locations. Sarah purchases an insurance policy knowing she has a higher probability of being injured. 

If the insurance company cannot distinguish between high-risk and low-risk buyers, it will set the premium based on the average risk. Many high-risk clients like Sarah purchase insurance because they are more likely to benefit from the insurance. 

The company increases premiums to cover the anticipated higher payouts. 

However, Mary, who works as a support staff member in an office, has a lower risk of injury. The premium is very expensive for her. So she does not buy the insurance policy. 

This leads to a pool of buyers where there are more high-risk individuals than low-risk individuals, illustrating the problem of adverse selection.