Adverse selection and market signaling

This chapter investigates problems of adverse selection. In problems of adverse selection, one party to a transaction knows things pertaining to the transaction that are relevant to but unknown by the second party. Here a classic example is life insurance, where the insuree may know things about the state of their health that are unknown by the insurer.

The “solution” to problems of adverse selection is market signaling, where the party in possession of superior information signals what they know through their actions. For example, an insurance company may offer life insurance on better terms if the insured is willing to accept very limited benefits for the first two or three years the policy is in effect, on the presumption that someone who suffers from ill health and is about to die is unwilling to accept those limited benefits.