What is adverse selection?
Adverse selection generally refers to a situation in which sellers have information that buyers do not have, or vice versa, about an aspect of product quality – in other words, it is a cases where asymmetric information is used. Asymmetric information, also known as information failure, occurs when one party to a transaction has greater material knowledge than the other.
Generally, the best informed party is the seller. Symmetrical information is when both parties have equal knowledge.
In the case of insurance, anti-selection is the tendency of people in dangerous jobs or high-risk lifestyles to buy products like life insurance. In these cases, it is the buyer who really has more knowledge (for example, about their health). To combat adverse selection, insurance companies reduce their exposure to large claims by limiting coverage or increasing premiums.
Understanding unfavorable selection
Unfavorable selection occurs when a party to a negotiation has relevant information that the other party does not have. Information asymmetry often leads to poor decisions, such as doing more business with less profitable or riskier market segments.
In the case of insurance, avoiding adverse selection requires identifying groups of people more at risk than the general population and charging them more money. For example, life insurance companies go through underwriting when evaluating whether to issue a policy to the claimant and the premium to be billed.
Policyholders generally assess height, weight, current health, medical history, family history, occupation, hobbies, driving record and lifestyle risks such as smoking all of these issues affect the claimant’s health and the company’s potential to pay a claim. The insurance company then determines whether to grant the claimant a policy and what premium to charge for taking that risk.
Unfavorable market selection
A seller may have better information than a buyer about the products and services offered, which puts the buyer at a disadvantage in the transaction. For example, company executives may be more willing to issue shares if they know that the stock price is overvalued relative to the real value; buyers may end up buying overvalued stocks and lose money. In the used car market, a seller can be aware of a vehicle defect and charge more to the buyer without disclosing the problem.
Unfavorable selection in insurance
Because of adverse selection, insurers find that people at high risk are more willing to underwrite and pay higher premiums for policies. If the company charges an average price but only high-risk consumers buy, the company suffers a financial loss by paying more benefits or claims.
However, by increasing the premiums of high-risk policyholders, the company has more money to pay for these benefits. For example, a life insurance company charges higher premiums to drivers of racing cars. An auto insurance company charges more for customers living in high-crime areas. A health insurance company charges higher premiums to customers who smoke. On the other hand, clients who do not engage in risky behavior are less likely to pay for insurance due to the increase in policy costs.
An excellent example of unfavorable selection regarding life or health insurance coverage is a smoker who successfully obtains insurance coverage as a non-smoker. Smoking is a key risk factor identified for life or health insurance, so a smoker must pay higher premiums to get the same level of coverage as a non-smoker. By concealing his behavioral choice to smoke, a candidate leads the insurance company to make decisions on the coverage or the costs of the premiums that affect the insurance company’s financial risk management.
Another example of unfavorable selection in the case of auto insurance would be a situation where the claimant obtains insurance coverage based on the provision of a residential address in an area with a very low crime rate while the claimant resides really in an area with a very high crime rate. . Obviously, the risk of the plaintiff’s vehicle being stolen, vandalized or otherwise damaged when it is regularly parked in a high crime area is considerably higher than if the vehicle was regularly parked in a low crime area.
Unfavorable selection may occur on a smaller scale if an applicant declares that the vehicle is parked in a garage every night while it is actually parked on a busy street.
Key points to remember
- Adverse selection occurs when sellers have information that buyers do not have, or vice versa, about an aspect of product quality.
- It is therefore the tendency of those in dangerous jobs or in a high-risk lifestyle to take out life or disability insurance where the chances are greater that they will benefit.
- A seller may also have better information than a buyer about the products and services offered, which puts the buyer at a disadvantage in the transaction. For example in the used car market.
Moral risk against unfavorable selection
Just like adverse selection, moral hazard occurs when there is asymmetric information between two parties, but when a change in behavior of a party is exposed after the conclusion of an agreement. Unfavorable selection occurs when there is a lack of symmetrical information before to an agreement between a buyer and a seller.
Moral risk is the risk that a party may not have entered into the contract in good faith or provided false details of its assets, liabilities or credit capacity. For example, in the investment banking industry, we know that government regulators will bail out failing banks; as a result, bank workers can take excessive risks to get lucrative bonuses knowing that if their risky bets do not materialize, the bank will be saved anyway.
Example of unfavorable selection: the lemon market
The problem of lemons refers to problems that arise regarding the value of an investment or product due to asymmetric information held by the buyer and the seller.
The lemons problem was highlighted in a research paper, “The ‘lemons’ market: quality uncertainty and the market mechanism”, written in the late 1960s by George A. Akerlof, economist and professor at the University of California at Berkeley. The keyword identifying the problem comes from the example of used cars used by Akerlof to illustrate the concept of asymmetric information, because faulty used cars are commonly called lemons.
The problem of lemons exists in the market for consumer and commercial products, as well as in the area of investment, linked to the disparity in the perceived value of an investment between buyers and sellers. The problem of lemons is also widespread in the financial sector, including the insurance and credit markets. For example, in corporate finance, a lender has asymmetric and less than ideal information about a borrower’s real credit standing.