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Adverse selection occurs when one party in a transaction has more information than the other.  This often happens in insurance and finance-related activities.  The bank or insurance company offering the service attracts (and thus adversely selects) customers that make the service being offered unprofitable or less profitable. To prevent adverse selection, companies must either place controls on the use of their product or enact better customer screening procedures.

Insurance companies face the most risk from adverse selection.  If they offer insurance policies at a specific premium price, but fail to factor in a risk that is unknown to them at the time, then they will find themselves paying for more claims than anticipated, and the insurance will be unprofitable.

For instance ABC Insurance Corporation quoted Jim a $50 a month premium for term life insurance.  If ABC failed to ask, and Jim failed to disclose, the fact that he is an avid skydiver, then ABC is taking more risk on insuring Jim’s life than bargained for. If this is a flaw in the ABC insurance contract, more avid thrill-seeking sports enthusiasts will purchase insurance from ABC, and ABC’s life insurance business will become unprofitable. 

To protect themselves from situations like this, most insurance companies add language to their insurance contracts that negate the contract if the purchaser fails to disclose information such as engaging in high-risk activities.

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