Adverse SelectionExplained & Defined
What is Adverse Selection?
Adverse selection is when one party knows a specific condition or quality of a product that the others don’t have.
It could be that sellers have more information over the customer or vice versa.
This gives an advantage to one party over the other.
Most of the time, the seller benefits more from this kind of information.
When one party has more knowledge over the other, the condition is called a piece of asymmetric information.
When both parties have equal information and knowledge, it is called symmetric information.
For example, in the insurance industry, the consumer who works in high-risk jobs or has dangerous lifestyles has a greater advantage with the information about their health condition and the need for life insurance.
The adverse selection here is the information that a person has over an insurance provider.
To give a solution to this adverse selection, the insurance company may implement a policy relative to the maximum amount of coverage customers may claim.
Understanding Adverse Selection
Adverse selection happens when one party makes an unfavorable decision and therefore suffers the consequences from it because he or she lacks a significant piece of information caused by information asymmetry.
Information asymmetry only means the other party has a greater advantage or disadvantage in decision-making because of what one person knows and the other does not.
In the insurance industry, insurance providers may fall into the disadvantages of adverse selection if they do not carefully detail the inclusions and exclusions of a policy.
To avoid adverse selection, a team of underwriters evaluates the information that prospective policyholders provide in terms of their health declarations.
After the evaluation, a premium amount is then decided based on the policy to be provided.
Essentially, high-risk policyholders pay more premium on the insurance.
An evaluation of the customer’s health status, personal information, and other pertinent data is gathered by an insurance underwriter.
Typically, these underwriters are risk assessors, and through their assessment, the insurer will decide on the applicable policy and premium to charge the customer for taking on the risks related to a customer’s health condition.
Adverse Selection in the Marketplace
Most of the time, sellers are at an advantage when offering products or services because they have more information than the customers.
For example, a seller may offer a certain product at a bargain price and the buyer will then grab the chance to acquire the same at a lower price.
The buyer will think it was a good buy without knowing that the product has minor defects – the reason why it was sold at a lower price than its market value in the first place.
Adverse Selection in Insurance
The insurance market is one industry where adverse selection is crucial for providers to match a policy against the premium they charge.
This is why customers who are high-risk are willing to pay more on insurance premiums because of the risks that insurance providers are willing to cover.
If an insurance provider sells a product to all customers for the same price regardless of the risk, it will ultimately suffer financial loss.
To address this, insurance companies charge those who are considered high-risk higher premiums.
For example, those who have pre-existing medical conditions, smoke, or have high-risk jobs pay more premiums on their insurance policies.
In contrast, those who are young, healthy, and do not engage in risky activities pay less on insurance premiums.
Similarly, when companies apply for property insurance, factors that drive the premiums are the total assets that the company plans to declare, the location where the office is located, etc.
If the office is located in an area with a high crime rate, the insurance premium on the policy will be much higher as compared to an area in a high-end business district.
Moral Hazard vs. Adverse Selection
A Moral Hazard occurs when one party enters into a contract in bad faith or has given false information.
It is one thing for one party to have the advantage of having more information over the other, but to intentionally take advantage of the other party is another.
A moral hazard is a practice whereby one party deliberately tricks the other party to enter into a contract.
In financial aspects, the convincing party may provide a false higher profitability rate just to lure the other party to invest in the company.
But in reality, the company can barely generate an income.
The Lemons Problem
Lemon problems occur when one party benefits from an overvalue of an investment or a product due to information asymmetry or vice versa.
The research study “The Market for ’Lemons’: Quality Uncertainty and the Market Mechanism,” was written by George A. Akerlof, an economist, and professor at the University of California, Berkeley in 1960.
The basis of this study was to demonstrate how asymmetric information occurs in the sale of used cars which are defective, referred to as lemons.
The Lemons problem is prevalent in almost all industries.
In the financing industry, a credit provider may have asymmetrical information through credit scoring companies about the creditworthiness of a borrower and will either charge a higher than the average interest rate, or a shorter repayment period or may reject the credit application.
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University of Chicago "Market Transparency, Adverse Selection, and Moral Hazard" Publication. August 4, 2022