Adverse financial selection, also known as adverse selection in finance, is a phenomenon in which individuals or companies with higher risk levels are more likely to take part in financial transactions compared to those with lower risk levels. This term is commonly used in the field of insurance and financial markets.
In adverse financial selection, the outcome of a transaction tends to be unfavorable or adverse because the higher-risk participants are more likely to be involved. This occurs when information asymmetry exists between the parties involved, meaning that one party possesses more or better information about their risk levels than the other party.
Insurance companies are often affected by adverse financial selection. They may find that higher-risk individuals are more inclined to purchase insurance policies because they are more likely to require coverage. This leads to increased claims and a higher potential for losses for the insurance company. Consequently, insurance companies often establish risk assessment mechanisms, such as health screenings or risk profiling, to counter adverse financial selection and appropriately price their insurance policies.
In financial markets, adverse financial selection can take place when the market is dominated by individuals or companies with weaker financial positions, increasing the overall risk level of the market. This can result in higher borrowing costs for those seeking funds, discouraging potential borrowers and potentially distorting market efficiency.
In summary, adverse financial selection refers to the tendency for higher-risk participants to dominate financial transactions due to information asymmetry, potentially leading to unfavorable outcomes and higher risk levels within markets or industries.
