Today, we are going to discuss an interesting phenomenon in the world of game theory: namely, adverse selection. Frequently, game theory attempts to isolate and analyze curious phenomena and detect the essential elements that make it work. We can then try and manipulate these element to steer the game in a chosen direction.

The phenomenon of adverse selection occurs when several people are trying to obtain a particular goal, and the criteria which make the person either suitable or unsuitable to obtain that goal from the point of view of the entity and from the person trying to obtain it are diametrically opposite.

Let us take the example of a company who is trying to project to the world that only the most stylish and fashionable people wear their watches. To accomplish this, it decides to selectively sell their watches only to the most fashionable people in the world. From the point of view of the watch company, the people who must wear it must be really stylish and fashionable. However, the people who will most want to wear the watch will be wannabes. The wannabes will benefit most from the watch since, if they have the watch, they will be projected as stylish and fashionable. Hence, the watch company must be very suspicious of anyone who desperately wants to wear the watch.

Those who are really stylish and fashionable will not want to wear the watch so badly since their reputation is already made and they gain little from wearing it.

Adverse selection is characterized by the fact that people who most want to obtain something are typically the least worthy to have it.

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This manifests itself beautifully in the case of insurance companies. Regardless of what anyone says, insurance is essentially gambling. Insurance students will cut my throat out for saying this, but when all the smoke clears, it’s pretty obvious that when you take out an insurance, you’re hedging your bets.

Since insurance companies want to maximize their profits, they will want to have the odds stacked on their side. This means that they will want to give insurance to people who are least likely to demand a payout from them. On the other hand, those who most badly want insurance will be the people who are most likely to demand a payout.

A person who is old and has several ailments would love to have cheap insurance, whereas a young man in perfect health will have less to gain. However, insurance companies want the young man to sign up for insurance and not the old person. This is adverse selection in its most characteristic form.

It’s actually somewhat tragic. Giving insurance only to those who don’t want it completely defeats the purpose of insurance from the customer’s point of view. What’s the big idea of refusing insurance to those who need it most? That’s like selling pizza to a person who isn’t hungry! However, adverse selection doesn’t apply in the case of pizza.

Since insurance companies don’t play fair by testing people and even excluding some people from insurance based on their riskiness, the people who want insurance are perfectly justified in trying to fool the insurance companies by hiding their ailments. It’s a dance, and the outcome all depends on whether the insurance company can discover the hidden ailments of the person or not.

There is no stable solution to this. In other words, no Nash equilibrium exists. One of the parties will always wish that they had – or didn’t have – insurance, or the insurance company will always wish that they had – or didn’t have – a certain person’s business. A zero sum game. In the end, both parties can be happy only if they assess the situation differently. That is, each thinks that they have outwitted the other.