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Adverse selection

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Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, statistics, and risk management. It refers to a market process in which "bad" results occur when buyers and sellers have asymmetric information (i.e. access to different information): the "bad" products or customers are more likely to be selected. A bank that sets one price for all its checking account customers runs the risk of being adversely selected against by its low-balance, high-activity (and hence least profitable) customers. Two ways to model adverse selection are with signaling games and screening games.

Example: insurance

The term adverse selection was originally used in insurance. It describes a situation where an individual's demand for insurance (either the propensity to buy insurance, or the quantity purchased, or both) is positively correlated with the individual's risk of loss (e.g. higher risks buy more insurance), and the insurer is unable to allow for this correlation in the price of insurance[1]. This may be because of private information known only to the individual (information asymmetry), or because of regulations or social norms which prevent the insurer from using certain categories of known information to set prices (e.g. the insurer may be prohibited from using information such as gender or ethnic origin or genetic test results). The latter scenario is sometimes referred to as 'regulatory adverse selection'.[2]

The potentially 'adverse' nature of this phenomenon can be illustrated by the link between smoking status and mortality. Non-smokers, on average, are more likely to live longer, while smokers, on average, are more likely to die younger. If insurers do not vary prices for life insurance according to smoking status, life insurance will be a better buy for smokers than for non-smokers. So smokers may be more likely to buy insurance, or may tend to buy larger amounts, than non-smokers. The average mortality of the combined policyholder group will be higher than the average mortality of the general population. From the insurer's viewpoint, the higher mortality of the group which 'selects' to buy insurance is 'adverse'. The insurer raises the price of insurance accordingly. As a consequence, non-smokers may be less likely to buy insurance (or may buy smaller amounts) than if they could buy at a lower price to reflect their lower risk. The reduction in insurance purchase by non-smokers is also 'adverse' from the insurer's viewpoint, and perhaps also from a public policy viewpoint.

Furthermore, if there is a range of increasing risk categories in the population, the increase in the insurance price due to adverse selection may lead the lowest remaining risks to cancel or not renew their insurance. This leads to a further increase in price, and hence the lowest remaining risks cancel their insurance, leading to a further increase in price, and so on. Eventually this 'adverse selection spiral' might in theory lead to the collapse of the insurance market.

To counter the effects of adverse selection, insurers (to the extent that laws permit) ask a range of questions and may request medical or other reports on individuals who apply to buy insurance, so that the price quoted can be varied accordingly, and any unreasonably high or unpredictable risks rejected. This risk selection process is known as underwriting. In many countries, insurance law incorporates an 'utmost good faith' or uberrima fides doctrine which requires potential customers to answer any underwriting questions asked by the insurer fully and honestly; if they fail to do this, the insurer may later refuse to pay claims.

Whilst adverse selection in theory seems an obvious and inevitable consequence of economic incentives, empirical evidence is mixed. Several studies investigating correlations between risk and insurance purchase have failed to show the predicted positive correlation for life insurance[3], auto insurance[4][5], and health insurance[6]. On the other hand, "positive" test results for adverse selection have been reported in health insurance [7], long-term care insurance[8] and annuity markets[9]. These "positive" results tend to be based on demonstrating more subtle relationships between risk and purchasing behavior (e.g. between mortality and whether the customer chooses a life annuity which is fixed or inflation-linked), rather than simple correlations of risk and quantity purchased.

One reason why adverse selection may be muted in practice may be that insurers' underwriting is largely effective. Another possible reason is negative correlation between risk aversion (e.g. insurance purchasers) and risk level (e.g. level of observed claims) in the population: if risk aversion is higher amongst lower risk customers, adverse selection can be reduced or even reversed, leading to 'propitious' or 'advantageous' selection[10][11]. For example, there is evidence that smokers are more willing to do risky jobs than non-smokers[12], and this greater willingness to accept risk might reduce insurance purchase by smokers. From a public policy viewpoint, some adverse selection can also be advantageous because it may lead to a higher fraction of total losses for the whole population being covered by insurance than if there were no adverse selection[13].

In studies of health insurance, an individual mandate requiring people to either purchase plans or face a penalty is cited as a way out of the adverse selection problem by broadening the risk pool.[14]

See also

References

  1. ^ Adverse Selection by Seth J. Chandler, The Wolfram Demonstrations Project
  2. ^ Polborn, M.K., Hoy, M. & Sadanand, A: "Advantageous Effects of Regulatory Adverse Selection in the Life Insurance Market", Economic Journal, 116, 508: 327-354.
  3. ^ Cawley, J. & Philipson, T: "An Empirical Examination of Barriers to Trade in Insurance", American Economic Review, 89:827-846.
  4. ^ Chiappori, P.A. & Salanie, B: "Testing for Asymmetric Information in Insurance Markets", Journal of Political Economy, 108:56-78.
  5. ^ Dionne, G. Gouriéroux, C. & Vanasse, C:, "Testing for Evidence of Adverse Selection in the Automobile Insurance Market: A Comment" Journal of Political Economy, 109: 444-453.
  6. ^ Cardon, J.H. & Hendel, I: "Asymmetric information in health insurance: evidence from the National Medical Expenditure Survey", Rand Journal of Economics, 32:408-427.
  7. ^ Cardon, J.H. & Hendel, I: "Adverse Selection in Health Insurance", NBER, Working Paper No. 6107.
  8. ^ Finkelstein, A. & McGarry, K: "Multiple dimensions of private information: evidence from the long-term care insurance market", American Economic Review, 96: 938-958..
  9. ^ Finkelstein, A. & Poterba, J: "Adverse selection in insurance markets: policyholder evidence from the UK annuity market", Journal of Political Economy, 112: 183-208.
  10. ^ Hemenway, D: "Propitious selection", Quarterly Journal of Economics, 105: 1063-1069.
  11. ^ De Meza, D. & Webb, D.C: "Advantageous selection in insurance markets", RAND Journal of Economics, 32: 249-262.
  12. ^ Viscusi, W.K. & Hersch, J: "Cigarette smokers as job risk takers", Review of Economics and Statistics, 83: 269-280.
  13. ^ Thomas, R.G: "Loss coverage as a public policy objective for risk classification schemes", Journal of Risk & Insurance, 75: 997-1018.
  14. ^ http://content.nejm.org/cgi/content/full/361/1/6
  • Akerlof, G. A. (1970). The market for" lemons": Quality uncertainty and the market mechanism. The Quarterly Journal of Economics, 84(3), 488-500.
  • The Economist: Research Tools, Adverse Selection [1]
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