Adverse Selection ? a definition, some ... - Business Risk Management

In class on Tuesday, we will discuss the problem of adverse selection. Adverse selection is often referred to as the ?hidden information? problem. Although most of our (analytic) discussion will focus on insurance examples, it is important to note that adverse selection occurs in many market settings other than insurance markets. Adverse selection occurs whenever one party to a contract has superior information compared with his or her counter-party. When this occurs, often the party with the information advantage is inclined to take advantage of the uninformed party.

In an insurance setting, adverse selection is an issue whenever insurers know less about the true risk characteristics of their policyholders than the policyholders themselves. In lending markets, banks have limited information about their clients? willingness and ability to pay back on their loan commitments. In the used car market, the seller of a used car has more information about the car that is for sale than potential buyers. In the labor market, employers typically know less than the worker does about his or her abilities. In product markets, the product?s manufacturer often knows more about product failure rates than the consumer, and so forth?

The problem with adverse selection is that if left unchecked, it can undermine the ability of firms and consumers to enter into contractual relationships, and in extreme cases, may even give rise to so-called market failures. For example, in the used car market, since the seller has more information than the buyer about the condition of the vehicle, the buyer cannot help but be naturally suspicious concerning product quality. Consequently, he or she may not be willing to pay as much for the car as it is worth (if in fact it is not a lemon). Similarly insurers may be reticent about selling policies to bad risks, banks may be worried about loaning money to poor credit risks, employers may be concerned about hiring poor quality workers, consumers may be worried about buying poor quality products, and so forth?

A number of different strategies exist for mitigating adverse selection. In financial services markets, risk classification represents a particularly important strategy. The reason why insurers and banks want to know your credit score is because consumers with bad credit not only often lack the willingness and ability to pay their debts, but they also tend to have more accidents than consumers with good credit. Signaling is used in various settings; for example, one solution to the ?lemons? problem in the market for used cars is for the seller to ?signal? by providing credible third party certification; e.g., by paying for Carfax reports or for vehicle inspections by an independent third party organization. Students ?signal? their quality by selecting a high quality university (e.g., like Baylor! ). Here the university provides potential employers with credible third party certification concerning the quality of human capital. In product markets, if a manufacturer is willing or provide a long-term warranty, this may indicate that quality is better than average.

Sometimes it?s not possible to fully mitigate adverse selection via the methods described above. Our class discussion on Tuesday will show, among other things, that insurers commonly employ pricing and contract design strategies which incentivize policyholders to voluntarily reveal their true risk characteristics according to their contract choices. So basically we obtain a ?separating equilibrium? in which high risk insureds voluntarily select ?high risk? contracts whereas low risk insureds voluntarily select ?low risk? contracts.

Source: http://risk.garven.com/2012/03/04/adverse_selection/

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