Adverse Selection
What is Adverse Selection?
Adverse selection occurs when asymmetric information leads undesirable participants to dominate a market before a transaction takes place.
For example, if insurers cannot tell high-risk from low-risk buyers, mostly high-risk people buy insurance, raising prices and driving out low-risk buyers. It stems from hidden information before a deal is made. Screening and signaling help reduce it.
Adverse Selection: a worked example
An insurer faces 800 potential customers: 500 low risk people whose expected claims are 300 dollars a year, and 300 high risk people whose expected claims are 900 dollars. Unable to tell them apart, the insurer charges the pool average, (500 x 300 + 300 x 900) divided by 800, which is (150,000 + 270,000) divided by 800 = 525 dollars. The low risk group values coverage at no more than 400 dollars, so all 500 of them decline, even though a policy priced at their own risk would have sold. The pool left behind is 300 high risk buyers averaging 900 dollars in claims, so the premium has to climb to 900 just to break even. With more than two risk types the step repeats, each rise pushing out the safest buyers still holding a policy, which is the pattern called a death spiral.
The mistake students make with adverse selection
The classic error is writing that adverse selection requires somebody to lie. Nobody deceives anyone in the example, since the low risk customers simply read the premium, judge it a bad deal, and walk away. A second slip is assuming the informed side is always the seller. In an insurance market the buyer holds the private information, about his own health or his own driving, so the side the market cannot see through is the one handing over money. Ask who knows the hidden trait before deciding which group withdraws.
Adverse Selection questions
What is an example of adverse selection?
Health insurance offers the standard case. When an insurer must charge one premium and cannot observe who is sick, people expecting large medical bills sign up eagerly while healthy people judge the coverage overpriced and stay out. The pool left behind is sicker than average, the premium rises, and the next healthiest group leaves. Annuities show the mirror image, since the buyers keenest to lock in an income for life are the ones expecting to live longest, forcing the seller to price for a long lived customer.
How is adverse selection different from moral hazard?
Adverse selection happens before an agreement and concerns hidden characteristics, meaning which type of person chooses to buy. Moral hazard happens after the agreement and concerns hidden actions, meaning how the covered party behaves once protected. A driver with a poor record buying the most generous policy available is adverse selection. That same driver skipping the garage and parking on the street once insured is moral hazard. Screening addresses the first, while deductibles and monitoring address the second.
How can adverse selection be reduced?
Screening lets the uninformed side sort the informed side, using medical questionnaires, vehicle inspections, or credit checks. Signaling works from the other direction, with the informed party paying for something only a good type would find worthwhile, such as a transferable warranty or a costly qualification. Compulsory or automatic enrollment removes the choice that drives the sorting, which is why a group plan covering every employee prices much closer to the true population average than an individual plan does.
Related terms
Common comparisons
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