Adverse selection is a concept in economics, insurance, and risk management, which captures the idea of a "rigged" trade. When buyers and sellers have access to different information (asymmetric information), traders with better private information about the quality of a product will selectively participate in trades which benefit them the most (at the expense of the other trader). A textbook example is Akerlof's market for lemons.
Buyers sometimes have better information about how much benefit they can extract from a service in which case the "bad" customers are more likely to apply for the service. For example, an all-you-can-eat buffet restaurant which sets one price for all customers risks being adversely selected against by high appetite (and hence least profitable) customers. Another example is in offering health insurance, the types of customers most likely to apply are those who are most prone to accidents.
An example where the buyer is adversely selected against is in financial markets. A company is more likely to offer stock when managers privately know that the current stock price exceeds the fundamental value of the firm. Uninformed investors rationally demand a premium to participate in the equity offer.
The term "adverse selection" was originally used in insurance. It describes a situation where an individual's demand for insurance is positively correlated with the individual's risk of loss.
This can be illustrated by the link between smoking status and mortality. Non-smokers typically live longer than smokers. If a life insurance company does not vary prices according to smoking status, its life insurance will be more valuable for smokers than for non-smokers. Smokers will have greater incentives to buy insurance from that company and purchase insurance in larger amounts than non-smokers. The average mortality rate increases, leading to losses for the company.
In response, the company may increase premiums however, higher prices causes responsible non-smoking customers to cancel their insurance, which can exacerbate the adverse selection problem and lead to a collapse in the insurance market.
To counter the effects of adverse selection, insurers must offer insurance premiums that are proportional to the customer's risk of accident. The insurer must screen and distinguish high-risk individuals from low-risk individuals. Medical insurers for instance, ask a range of questions and may request medical or other reports on individuals who apply to buy insurance, so that the premium can be varied accordingly, and any unreasonably high or unpredictable risks rejected altogether. This risk selection process is one part of 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. Dishonesty may be met with refusals to pay claims.
Evidence of adverse selection in insurance markets
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, auto insurance, and health insurance. On the other hand, "positive" test results for adverse selection have been reported in health insurance, long-term care insurance, and annuity markets. These "positive" results tend to be based on demonstrating more subtle relationships between risk and purchasing behavior (such as 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.
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, such that persons less likely to engage in risk-increasing behavior are more likely to engage in risk-decreasing behavior (to take affirmative steps to reduce risk), adverse selection can be reduced or even reversed, leading to "advantageous" selection.
For example, there is evidence that smokers are more willing to do risky jobs than non-smokers, 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.
Adverse selection in 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 offerings other investors did not want. Assuming that managers have inside information about the firm, outsiders are most prone to adverse selection in equity offers since 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 since by offering debt, outside investors infer that managers believe the current stock price is undervalued. Managers 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" (Myers and Majluf, 1984).
Adverse selection in contract theory
In modern contract theory, the term "adverse selection" is now simply used to categorize principal-agent models in which an agent has private information already before a contract is written. 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, the term "moral hazard" is used for principal-agent models in which there is symmetric information at the time of contracting, while 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. 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 in models with private values (where the agent's type has a direct influence on his own preferences, e.g. his effort costs or his willingness-to-pay) and models with interdependent or common values (where the agent's type has a direct influence on the principal's preferences, e.g. the agent may be a seller who privately knows the quality of a car). Seminal contributions to the former case have been made by Roger Myerson and Eric Maskin, while the latter case has 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.
- Agency cost
- Contract theory
- Community rating
- Death spiral (insurance)
- Information asymmetry
- Market for lemons
- Moral hazard
- Principal–agent problem
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