Steve Bain

Adverse Selection Explained (with Examples)

The problem of adverse selection in economics relates to a situation where the same price is charged for products that have different levels of quality. It happens because of a mismatch in information between the buyer and the seller.

As a result of this asymmetric information, when it is sellers who lack information relative to buyers, too much of the high-quality items are sold and not enough low-quality items are sold, and vice-versa when buyers lack symmetric information.

This problem usually leads to market failure because it leads to either higher prices or fewer sales than would be the case if both parties had complete information. This is because the party with less information will likely know that his/her counterpart enjoys superior information about the product, and he/she will therefore proceed more cautiously.

Adverse selection is usually present in insurance and credit markets, where sellers are relatively lacking in information about the true risk level associated with any particular customer or product. A good example of this is offered by the banking crisis in 2008, when global financial institutions were exposed to greater mortgage default risks than they had anticipated. I will discuss this below, along with a second example relating to health insurance.

An Example of Adverse Selection in Banking & Credit

The 2008 financial crisis stands as a potent example of adverse selection in the market, illustrating how asymmetric information can lead to significant economic decline.

In the buildup to the crisis, a number of financial institutions engaged in risky mortgage lending practices, assuming that the continual rise in property prices would mitigate the inherent risk. Yet, the risks these companies undertook were largely underestimated or concealed, contributing to a market-wide underpricing of risk.

On instructions from the US government, high-risk mortgages had been bundled with low-risk mortgages into AAA-rated securities, but that rated grossly underestimated the true level of risk associated with these securities even as they were traded globally in large volumes.

As housing prices began to plummet and defaults increased, the adverse selection problem became clear. While companies possessed information on their own exposure to risky assets, the market did not have complete information about the AAA-rated mortgage-backed securities that they were heavily invested in, and they were severely mispriced as a result.

During the 2008 crisis, companies with significant holdings in mortgage-backed securities became acutely vulnerable. The increasing number of mortgage defaults as the housing market fell revealed the true level of risk associated with these AAA-rated securities. When the affected financial entities disclosed the full extent of their investments in these securities, the market responded sharply; leading to a dramatic unfolding of company-specific issues that affected the broader economy.

The unfolding crisis highlighted how the severance of information symmetry can lead to an erosion of market trust. News of failing companies spread, further inflating the sense of risk and prompting a spike in premiums to insure against potential defaults. Investors, learning of the discrepancies in information, recalibrated the prices they were willing to pay for certain securities sending shockwaves through the market.

Liquidity in the entire global financial system quickly dried up, prompting massive government bailouts in order to prevent a collapse of the banking and finance sector – something that would have destroyed entire stock markets, pensions & savings accounts, and sent the world economy into a new Great Depression.

In retrospect, had the prices of these mortgage-backed securities truly reflected the high level of risk based on complete information, the market may have avoided one of the gravest economic declines in modern history.

Monetary Management and Banking Solutions

Companies, especially those in the banking sector, encounter adverse selection when borrowers with the highest likelihood of default are the ones most eager to accept loans. This risk is amplified during economic downturns when businesses and individuals have to combat falling profits and salaries.

To combat this, monetary and banking institutions often implement regulations and strategies akin to insurance against macroeconomic decline. Such measures aim to preserve market integrity, facilitate financial stability, and offer protection against systemic risks that potentially catalyze a decline in the functioning of the economy.

An Example of Adverse Selection in Health Insurance

Adverse selection represents a significant dilemma for sellers within insurance markets, particularly those offering health insurance products. This problem arises when there is an information asymmetry between the insurance companies and the party seeking insurance.

Essentially, the party with greater information about their health risks is more inclined to purchase health insurance if they know their health to be bad, often leading to a situation where insurance sellers are disproportionately servicing high-risk individuals. From the perspective of sellers, managing the cost and pricing of premiums in light of adverse selection is a complex balancing act.

On the flip-side, people who know their health to be good are more likely to skip insurance altogether because the prices being charged are likely to be deemed too high given their good health.

If sellers are unaware of the individual health risks presented by each potential customer, they may inadvertently set premiums at a level that is unattractive for low-risk individuals yet highly appealing to those at higher risk. Over time, this can skew the risk pool as only people with bad health take up insurance. This pressures sellers into escalating premiums even further to cover the increasing likelihood of having to pay out claims. This is not merely a theoretical situation; it mirrors issues observed in various insurance markets globally.

Types of adverse selection in Insurance

One type of adverse selection is called ‘cream skimming’, this occurs when insurance companies selectively target lower-risk individuals, leaving higher-risk individuals with limited coverage options. Insurers do this to minimize potential losses, but it can exacerbate adverse selection effects by creating a pool of high-risk individuals who lack adequate insurance.

Another type is ‘anti-selection’, which is the opposite of cream skimming. In this scenario, higher-risk individuals actively seek out insurance coverage, while lower-risk individuals opt out. This can happen when insurance premiums are not priced appropriately to reflect the risk level, making insurance attractive to those who are more likely to file a claim.

Solutions

Insurance companies employ various strategies to combat adverse selection and maintain a balanced risk pool. A common approach is underwriting, which involves extra assessment of individual risk levels before providing coverage. By carefully evaluating factors such as age, pre-existing health conditions, occupational risk factors, driving records etc., insurers can adjust premiums and coverage options accordingly.

Another strategy is the use of risk pools, where insurers create separate risk pools for different segments of the market in order to minimize adverse selection effects. This allows them to offer tailored coverage options and pricing based on the specific risk profiles of each group.

Insurers also utilize marketing and education campaigns to attract a balanced mix of policyholders. By promoting the value of insurance to low-risk individuals and highlighting the potential consequences of being uninsured, insurers can encourage a more diverse risk pool and thereby mitigate adverse selection costs.

Adverse selection vs. Moral Hazard

While adverse selection and moral hazard are related concepts, they differ in crucial ways. Adverse selection occurs before insurance coverage is obtained, where individuals with higher risks are more likely to seek coverage. In contrast, moral hazard refers to the change in behavior that occurs after individuals have insurance coverage.

When people know that they are protected by insurance, they may engage in riskier activities, leading to higher claim rates and increased costs for insurers. This moral hazard can contribute to adverse selection as insurers struggle to differentiate between those who are genuinely high-risk and those who engage in riskier behaviors due to having insurance coverage.

Adverse selection focuses on the selection of policyholders, while moral hazard focuses on the behavior of policyholders. Both concepts pose challenges for insurers, but they require distinct strategies to mitigate their respective impacts.

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