Adverse selection

In economics, insurance, and risk management, adverse selection is a market situation where buyers and sellers have different information, so that a participant might participate selectively in trades which benefit them the most, at the expense of the other party. A standard example is the market for used cars with hidden flaws ("lemons").

The party without the information is worried about an unfair ("rigged") trade, which occurs when the party who has all the information uses it to their advantage. The fear of rigged trade can prompt the worried party to withdraw from the interaction, diminishing the volume of trade in the market. This can cause a knock-on effect and through a positive feedback loop, will lead to the unraveling of the market. An additional implication of this potential for market collapse is that it can act as an entry deterrence that leads to higher profit margins for existing competitors without additional entry.

In certain situations, the buyer may know the value of a good or service better than the seller. For example, a restaurant offering "all you can eat" at a fixed price may attract customers with a larger than average appetite, resulting in a loss for the restaurant.

History

Adverse selection has been discussed for life insurance since the 1860s,[1] and the phrase has been used since the 1870s.[2]

George Akerlof in his 1970 paper, "The Market for 'Lemons'", highlights the effect adverse selection has in the used car market, creating an imbalance between the sellers and the buyers that may lead to a market collapse. The paper further describes the effects of adverse selection in insurance as an example of the effect of information asymmetry on markets,[3] a sort of "generalized Gresham's law".[4] Since then, "adverse selection" has been widely used in many domains.

Moral hazard
Main article: Moral hazard

A related form of market failure is moral hazard. With moral hazard, the asymmetric information between the parties causes one party to increase their risk exposure after the transaction is concluded, whereas adverse selection occurs before. Moral hazard suggests that customers who have insurance may be more likely to behave recklessly than those who do not. Adverse selection, on the other hand, suggests that customers will withhold information about existing health conditions from the health insurer when purchasing insurance.

Examples


Insurance

Adverse selection was first described for life insurance. It creates a demand for insurance which is positively correlated with the insured's risk of loss.[1]

For example, non-smokers typically live longer than smokers. If the price of insurance does not vary according to smoking status, then it will be more valuable for smokers than for non-smokers. Thus smokers will have a greater incentive to buy insurance and will purchase more insurance than non-smokers. This increases the average mortality rate of the insured pool, causing the insurer to pay more claims.

In response, the company may increase premiums to correspond to the higher average risk. However, higher prices cause rational non-smokers to cancel their insurance as insurance becomes uneconomic for them, exacerbating the adverse selection problem. Eventually, higher prices will push out all non-smokers in search of better options, and the only people left who will be willing to purchase insurance are smokers.

To counter the effects of adverse selection, insurers may offer premiums that are proportional to a customer's risk by distinguishing high-risk individuals from low-risk individuals. For instance, medical insurance companies ask a range of questions and may request medical or other reports on individuals who apply to buy insurance. The premium can be varied accordingly and any unreasonably high-risk individuals are rejected (cf. pre-existing condition). This risk selection process is part of underwriting. In many countries, insurance law incorporates an "utmost good faith" or uberrima fides doctrine, which requires potential customers to answer any questions asked by the insurer fully and honestly. Dishonesty may be met with refusals to pay claims.

Empirical evidence of adverse selection is mixed. Several studies investigating correlations between risk and insurance purchase have failed to show the predicted positive correlation for life insurance,[5] auto insurance,[6][7] and health insurance.[8] On the other hand, "positive" test results for adverse selection have been reported in health insurance,[9] long-term care insurance,[10] and annuity markets.[11]

Weak evidence of adverse selection in certain markets suggests that the underwriting process is effective at screening high-risk individuals. Another possible reason is the negative correlation between risk aversion (such as the willingness to purchase insurance) and risk level (estimated beforehand based on hindsight observation of the occurrence rate for other observed claims) in the population. If risk aversion is higher among lower-risk customers, adverse selection can be reduced or even reversed, leading to "advantageous" selection.[12][13] This occurs when a person is both less likely to engage in risk-increasing behavior are more likely to engage in risk-decreasing behavior, such as taking affirmative steps to reduce risk.

For example, there is evidence that smokers are more willing to do risky jobs than non-smokers.[14] This greater willingness to accept risk may reduce insurance policy purchases by smokers.

From a public policy viewpoint, some adverse selection can also be advantageous. Adverse selection may lead to a higher fraction of total losses for the whole population being covered by insurance than if there were no adverse selection.[15]

Capital markets

When raising capital, some types of securities are more prone to adverse selection than others. An equity offering for a company that reliably generates earnings at a good price will be bought up before an unknown company's offering, leaving the market filled with less desirable offerings that were unwanted by other investors. Assuming that managers have inside information about the firm, outsiders are most prone to adverse selection in equity offers. This is because managers may offer stock when they know the offer price exceeds their private assessments of the company's value. Outside investors, therefore, require a high rate of return on equity to compensate them for the risk of buying a "lemon".

Adverse selection costs are lower for debt offerings. When debt is offered, this acts as a signal to outside investors that the firm's management believes the current stock price is undervalued, as the firm would otherwise be keen on offering equity.

Thus the required returns on debt and equity are related to perceived adverse selection costs, implying that debt should be cheaper than equity as a source of external capital, forming a "pecking order".[16]

The example described assumes that the market does not know managers are selling stock. The market could gain access to this information, perhaps by finding it in company reports. In this case, the market will capitalize on the information found. If the market has access to the company's information, the presence of information asymmetry is removed, and as such there is no longer a state of adverse selection.

The presence of adverse selection in capital markets results in excessive private investment. Projects that otherwise would not have received investments due to having a lower expected return than the opportunity cost of capital, received funding as a result of information asymmetry in the market. As such, governments must account for the presence of adverse selection in the implementation of public policies.[17]

Contract theory
Main article: Principal–agent problem

In modern contract theory, "adverse selection" characterizes principal-agent models in which an agent has private information before a contract is written.[18][19] For example, a worker may know his effort costs (or a buyer may know his willingness-to-pay) before an employer (or a seller) makes a contract offer. In contrast, "moral hazard" characterizes principal-agent models where there is symmetric information at the time of contracting. The agent may become privately informed after the contract is written. According to Hart and Holmström (1987), moral hazard models are further subdivided into hidden action and hidden information models, depending on whether the agent becomes privately informed due to an unobservable action that he himself chooses or due to a random move by nature.[20] Hence, the difference between an adverse selection model and a hidden information (sometimes called hidden knowledge) model is simply the timing. In the former case, the agent is informed at the outset. In the latter case, he becomes privately informed after the contract has been signed.

Adverse selection models can be further categorized into models with private values and models with interdependent or common values. In models with private values, the agent's type has a direct influence on his own preferences. For example, he has knowledge over his effort costs or his willingness-to-pay. Alternatively, models with interdependent or common values occur when the agent's type has a direct influence on the principal's preferences. For instance, the agent may be a seller who privately knows the quality of a car.

Seminal contributions to private value models have been made by Roger Myerson and Eric Maskin, while interdependent or common value models have first been studied by George Akerlof. Adverse selection models with private values can also be further categorized by distinguishing between models with one-sided private information and two-sided private information. The most prominent result in the latter case is the Myerson-Satterthwaite theorem. More recently, contract-theoretic adverse selection models have been tested both in laboratory experiments and in the field.[21][22]

Reducing adverse selection

Reputation
Main article: Reputation

In markets where the seller has private information about the product they wish to sell, reputation mechanisms help to reduce adverse selection by acting as a signal of quality.[23] An example would be the online marketplace, Ebay. A seller known for selling high-quality goods can further enhance its reputation by utilising Ebay's reputation system. There is an incentive for the seller to do so, as buyers who derive utility from purchasing the product are naturally inclined to source their purchase from high-quality sellers. As such, buyers are able to rely on the reputation system as a signal to filter high-quality sellers from low-quality sellers.[24]

Lemon law
Main article: Lemon law

Lemon laws act as a form of consumer protection in the event the buyer purchase a defective product. While usually applied to automobiles, lemon laws are also used for most consumer goods. Such regulations were enacted to reduce cases where manufacturers knowingly sold defective products. Lemon laws vary by countries, but generally require the seller to repurchase the product or replace it. For example, the Texas Deceptive Trade Practices allows for consumers to sue for triple damages in the event of sustaining harm as a result of purchasing a defective product as a result of the seller withholding information at the time of the transaction. As such, such government regulations act as a deterrent against sellers exploiting the asymmetric information between the parties involved. This, in turn, reduces the problem of adverse selection, as buyers who are knowingly protected by lemon laws are more inclined to engage in transactions they previously would not have done so due to the lack of viable information available to them.

Warranties

By offering a warranty for the product the seller intends to sell, they are able to indirectly communicate private information about the product to the buyer. Warranties assist in conveying information about the seller's confidence in the product for its quality, by acting as a guarantee on the product.[25] A common example is in the used car market, where apart from warranties offered by the seller itself, the buyer may purchase additional warranties in the form of insurance from third-party companies.

See also

References
  1. "Royal Insurance—Statistics of its Operations", The Railway Times and Joint-Stock Chronicle, London, 23:38:1071 (September 22, 1860): "...such a selection continuing to be exercised will tend to neutralize the adverse effects of the exercise of selection which is possessed on the other hand by the assurer against the company"
  2. "The Insurance of Female Lives", The Chronicle (Chicago), 7:14:213 (April 6, 1871)
  3. Akerlof, p. 493
  4. Akerlof, p. 500
  5. Cawley, J.; Philipson, T. (1999). "An Empirical Examination of Barriers to Trade in Insurance" (PDF). American Economic Review. 89 (4): 827–846. doi:10.1257/aer.89.4.827. JSTOR 117161.
  6. Chiappori, P. A.; Salanie, B. (2000). "Testing for Asymmetric Information in Insurance Markets". Journal of Political Economy. 108 (1): 56–78. CiteSeerX 10.1.1.470.5388. doi:10.1086/262111.
  7. Dionne, G.; Gouriéroux, C.; Vanasse, C. (2001). "Testing for Evidence of Adverse Selection in the Automobile Insurance Market: A Comment". Journal of Political Economy. 109 (2): 444–453. doi:10.1086/319557.
  8. Cardon, J. H.; Hendel, I. (2001). "Asymmetric information in health insurance: evidence from the National Medical Expenditure Survey" (PDF). RAND Journal of Economics. 32 (3): 408–427. doi:10.2307/2696362. JSTOR 2696362.
  9. Cutler, David M.; Zeckhauser, Richard J. (1998). "Adverse Selection in Health Insurance". Forum for Health Economics & Policy. 1: Article 2. doi:10.2202/1558-9544.1056. Archived from the original on 2012-01-10. Retrieved 2011-07-30.
  10. Finkelstein, A.; McGarry, K. (2006). "Multiple dimensions of private information: evidence from the long-term care insurance market". American Economic Review. 96 (4): 938–958. doi:10.1257/aer.96.4.938. JSTOR 30034325. PMC 3022330. PMID 21253439.
  11. Finkelstein, A.; Poterba, J. (2004). "Adverse selection in insurance markets: policyholder evidence from the UK annuity market" (PDF). Journal of Political Economy. 112 (1): 183–208. doi:10.1086/379936.
  12. Hemenway, D. (1990). "Propitious selection". Quarterly Journal of Economics. 105 (4): 1063–1069. doi:10.2307/2937886. JSTOR 2937886.
  13. De Meza, D.; Webb, D. C. (2001). "Advantageous selection in insurance markets". RAND Journal of Economics. 32 (2): 249–262. doi:10.2307/2696408. JSTOR 2696408. S2CID 55494801.
  14. Viscusi, W. K.; Hersch, J. (2001). "Cigarette smokers as job risk takers". Review of Economics and Statistics. 83 (2): 269–280. doi:10.1162/00346530151143806. hdl:1803/6284.
  15. Thomas, R. G. (2008). "Loss coverage as a public policy objective for risk classification schemes". Journal of Risk & Insurance. 75 (4): 997–1018. CiteSeerX 10.1.1.554.1037. doi:10.1111/j.1539-6975.2008.00294.x.
  16. Myers, Stewart C.; Majluf, Nicholas S. (1984). "Corporate financing and investment decisions when firms have information that investors do not have". Journal of Financial Economics. 13 (2): 187–221. doi:10.1016/0304-405X(84)90023-0. hdl:1721.1/2068.
  17. Braido, Luis H. B.; da Costa, Carlos E.; Dahlby, Bev (2011). "Adverse Selection and Risk Aversion in Capital Markets". FinanzArchiv / Public Finance Analysis. 67 (4): 303–326. ISSN 0015-2218.
  18. Laffont, Jean Jacques; Martimort, David (2002). The theory of incentives: The principal-agent model. Princeton University Press.
  19. Bolton, Patrick; Dewatripont, Matthias (2005). Contract theory. MIT Press.
  20. Hart, Oliver; Holmström, Bengt (1987). "The theory of contracts". In Bewley, T. (ed.). Advances in Economic Theory. Cambridge University Press. pp. 71–155.
  21. Hoppe, Eva I.; Schmitz, Patrick W. (2015). "Do sellers offer menus of contracts to separate buyer types? An experimental test of adverse selection theory". Games and Economic Behavior. 89: 17–33. doi:10.1016/j.geb.2014.11.001.
  22. Chiappori, Pierre-Andre; Salanie, Bernard (2002). "Testing Contract Theory: A Survey of Some Recent Work". Rochester, NY. SSRN 318780. Cite journal requires |journal= (help)
  23. Mailath, George J.; Samuelson, Larry (2001). "Who Wants a Good Reputation?". The Review of Economic Studies. 68 (2): 415–441. ISSN 0034-6527.
  24. Saeedi, Maryam (2019). "Reputation and adverse selection: theory and evidence from eBay". The RAND Journal of Economics. 50 (4): 822–853. doi:10.1111/1756-2171.12297.
  25. Hollis, Aidan (1999). "Extended Warranties, Adverse Selection, and Aftermarkets". The Journal of Risk and Insurance. 66 (3): 321–343. doi:10.2307/253551. ISSN 0022-4367.

Further reading
  1. Bartram, Söhnke M.; Fehle, Frank R.; Shrider, David (May 2008). "Does Adverse Selection Affect Bid-Ask Spreads for Options?". Journal of Futures Markets. 28 (5): 417–437. doi:10.1002/fut.20316. SSRN 1089222.
  • William F Bluhm, "Cumulative Anti-Selection Theory," Society of Actuaries 50th Anniversary Monograph, Chapter 5, 1999.
  • The Economist: Information asymmetry, Secrets and agents,
  • The Economist: Research Tools, Adverse Selection
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