Definition: Adverse selection is a term used primarily in insurance although it is useful for other industries, as well. It refers to a situation in which the buyer or seller of a product knows something about the product quality or condition that the other party does not know, allowing them to have a better estimate of what the true cost of the product should be.
In the case of life and health insurance policies, for instance, adverse selection means that insurance is going to be more expensive than it should be for those who are healthy and responsible, and less expensive than it should be for those who are unhealthy and likely to need medical attention. The insurance company cannot possibly know the individual factors that determine every single person's health file, so insurance rates are overpriced to good risk and underpriced to bad risk. If not managed properly, adverse selection can result in a "book' of insurance business of extremely bad policies that will cost the company substantial sums of money and, in some cases, drive it out of business.
