What is adverse selection?

A situation where the seller of a product has more information than the buyer is called adverse selection. For example, a seller of used cars may sell cars without providing complete information to the buyer. This could also be the other way around where the buyer has more information than the seller. For example, a buyer of health insurance may have more information on their health than the seller. This asymmetry of information between the buyer and the seller could cause exploitation of one of the parties.

Adverse Selection
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Market place adverse selection

In a market, a seller may have more information on products than the buyer. This causes a disadvantage and a risk for the buyer. This risk may be more common in the secondhand goods market. Sellers of used cars are known for their asymmetrical information. An economics professor from California called George A Akerlof introduced the theory of the lemons problem in 1970 to better explain the asymmetry in information in the used cars market. Akerlof uses a scenario where a premium car and poorly maintained car are available in the market. Used car shoppers not knowing the true value of the cars may choose the average price of the two as their budget. The average price is between the premium and the bargain price. Since the average price is chosen, the premium car is no longer affordable. This results in the purchase of the poorly maintained car. In other words, due to asymmetrical information, poorly maintained cars force highly maintained cars out of the market. Akerlof suggests that the solution to such cases would be the existence of warranties for the buyer. This gives the buyer confidence about their purchase while also providing a guarantee for the product.

Finance adverse selection

The used car example can also apply to finance. Assume that there are two stocks available in the market where one has a good prospect while the other does not. If the investor is not risk-averse, he/she cannot tell a difference between the two stocks. The investor may once again choose an average price. This average price is likely to undervalue the good stocks taking them out of the market. The investor ends up investing in the stock with bad prospects.

Another type of adverse selection works in capital markets. For example, overvalued shares may be sold in large quantities by managers to investors. Managers may know the true value due to private assessments. They may sell these overvalued shares hiding the truth to maximize profits. Investors not knowing the true market value of shares may face the risk of loss when the value falls.

Insurance adverse selection

Insurance companies rely on information from their customers making them the most susceptible industry to adverse selection. This predominantly occurs in two main types of insurance: life insurance and health insurance.

Life insurance

In life insurance markets, insurance firms may be disadvantaged and at-risk as the policyholder may not give truthful information. For example, assume two individuals A and B are taking life insurance policies. A has diabetes and does not have a healthy lifestyle. B has no health conditions and has a healthy lifestyle. If the insurance firm cannot know the health status of the individuals, the interest may not be charged accurately. Individual A may choose to not disclose his diabetic condition to ensure he does not have to pay a higher premium. By hiding the truth, his interest rate stays the same as it does for a healthy individual. Therefore, he is wrongly categorized as a low-risk individual.

Health insurance

An imbalance of sick and healthy people holding health insurance policies can result in adverse selection. This imbalance is caused when unhealthy individuals buy more policies while healthy individuals do not buy a policy at all. This can increase the financial risk for the health insurance company while increasing the cost of the premium for the policyholders. Obama care introduced enrollment periods for insurance to avoid adverse selection. To get coverage for the financial year, the client must purchase health insurance only during the enrollment period and not when they are sick. This caused healthier individuals to enroll as they want coverage for the year they enroll. The Affordable Care Act (ACA) has also introduced changes such as reduced cost of premiums during the open and special enrollment period to encourage more individuals to purchase health insurance. Individuals are more willing to purchase insurance if they can get coverage while paying a premium at a low cost. The Obama care has also introduced an individual mandate where certain U.S. individuals must buy health insurance or face a tax penalty. However, all these initiatives have not yet completely eradicated the risk of adverse selection in the health insurance markets. There is always a possibility of market failure in the future.

Moral hazard vs Adverse selection

Both the terms moral hazard and adverse selection are used in economics and risk management where one party’s behavior negatively affects the other party.

Adverse selection refers to an agreement where either the buyer or seller has more information regarding the product that is being hidden.

On the other hand, a Moral hazard is where information asymmetry occurs between two parties, the behavior of one party changes after agreement. This behavior change may be done to avoid the consequences that may arise from the agreement. This behavior change could also be done by the buyer as he no longer faces consequences. For example, a buyer of car insurance may purposely drive recklessly as any damages done will be borne by the insurer and not the insured. Another example of a moral hazard could be an individual starting to smoke after the purchase of health insurance. Moral hazard also occurs commonly in lending, principal-agent, and employee-employer contracts.

Moral hazards can be effectively managed in three ways:

  1. Insurance firms can introduce a deductible to reduce their risk.
  2. Insurance firms can also classify their clients based on client history for easy monitoring.
  3. Policy renewal can be rejected by a health insurance company if continuous bad actions are observed.

Context and Applications

The aspiring students can pursue further specialization in this field into the following streams:

  • Bachelors in Business Administration (Financial Planning)
  • Bachelors in Business Administration (Risk Management) 
  • Masters in Business Administration (Risk Management)
  • Masters in Business Administration (Financial Planning)

Practice Problems

Question 1: Which economist published a research paper on the lemon theory using the used car business?

    1. Paul Samuelson
    2. Alfred Marshall
    3. George Akerlof
    4. Ludwig Von Mises

Answer: c

Explanation: George A Akerlof, an economist won the Nobel Prize for his lemon principle research paper published in 1970.

Question 2: Which party is likely to retain complete information while purchasing life insurance?

    1. Buyer
    2. Seller
    3. Financial advisor
    4. None of the above

Answer: a

Explanation: If the buyer of a life insurance plan is not a healthy individual, he/she may hide the fact that they are unhealthy or sick to reduce the premium. Therefore, the seller is at a risk that the buyer may retain private information.

Question 3: In which market are company managers likely to sell overvalued shares for profit?

    1. Money markets
    2. Capital markets
    3. Physical markets
    4. Insurance markets

Answer: b

Explanation: Shares are generally sold by companies in the capital market. In some cases, managers may oversell overvalued shares purposely while knowing the true share value.

Question 4: Which category of individuals is likely to have a low cost of insurance premium?

    1. Individual with disability
    2. Individual with disorder
    3. Individual over 50
    4. Healthy individual

Answer: d

Explanation: The healthier and younger the policyholder, the lower the requirement for insurance as they are not at risk. Therefore, the premium cost for healthy individuals is low even though the coverage may be similar.

Question 5: According to the lemon theory, what price is generally chosen by the used car shoppers?

    1. Fair price
    2. Bargain price
    3. Average price
    4. Premium price

Answer: c

Explanation: When given an option between premium price and bargain price, the used car shoppers are likely to choose an average price that makes the premium price unaffordable.

Common Mistakes

It is incorrect to assume that adverse selection and moral hazard cannot coexist. Asymmetrical information causes adverse selection however after an agreement takes place, one of the parties could change behavior as they no longer have to face economic consequences. Therefore, it is common for both concepts to coexist. This risk is especially present in the case of insurance.

While studying adverse selection, it is important to read the following topics to get a better knowledge:

  • Risk management
  • Insurance policies
  • Capital market investments

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