Drawing from George Akerlof’s groundbreaking paper on “The Market for Lemons,” adverse selection emerges as a problem that happens before contracts are signed, when buyers and sellers possess different levels of information about what’s being exchanged, specifically, how risky the potential policyholder is.
The heart of the issue? People or companies with higher-than-normal risk tend to seek insurance coverage more aggressively, especially when insurers can’t accurately tell different risk levels apart and must charge rates based on the group’s average risk. This pattern takes hold under particular circumstances: when the insured knows things about their own risk that the insurer doesn’t, when people’s decision to buy insurance depends heavily on price, and when there’s a clear link between how risky someone is and how much coverage they want.
The fallout can be dramatic – premiums might climb so high that safer customers walk away, shrinking the market to an inefficient size or even causing certain coverage types to vanish entirely. For insurers, this phenomenon restricts their ability to cover risks where private information plays a major role and risk classification proves tricky.
While health and life insurance often provide the textbook examples, marine insurance isn’t immune. Adverse selection lurks wherever shipowners hide information about how seaworthy their vessels truly are, what maintenance practices they follow, how fragile their cargo might be, or what kind of safety culture exists within their operation.