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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 trader. A textbook example is Akerlof's market for 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 the unraveling of the market. An additional implication of this potential for market collapse is that it can work as an entry deterrence that leads to high margins without additional entry.
Buyers sometimes have better information about how much benefit they can extract from a service. For example, an all-you-can-eat buffet restaurant that sets one price for all customers risks being adversely selected against by high appetite and hence, the least profitable customers. The restaurant has no way of knowing whether a given customer has a high or low appetite. The customer is the only one who knows if they have a high or low appetite. In this case the high appetite customers are more likely to use the information they have and to go to the restaurant.
In this case, the seller suffering from adverse selection can protect himself by screening customers or by identifying credible signals of appetite. Some examples of this phenomenon occur in signaling games and screening games.
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. While this example functions as a good hypothetical example of the buyer being adversely selected against, in reality the market can know that the managers are selling stocks (perhaps in required company reports). The market price of stocks will then reflect the information that managers are selling stocks.
Adverse selection is related to the concept of moral hazard. Where adverse selection describes a situation where the type of product is hidden from one party in a transaction, moral hazard describes a situation where there is a hidden action that results from the transaction. For example, the concept of moral hazard suggests that customers who have insurance may be more likely to behave recklessly than those who do not have insurance.
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 will purchase insurance in larger amounts than non-smokers. As smokers are at higher risk of early death due to their smoking status, and more smokers than non smokers will purchase life insurance, the average mortality rate increases. This increase means the insurer will spend more on policy payments, leading to losses.
In response, the company may increase premiums. However, higher prices cause rational non-smoking customers to cancel their insurance. The higher prices combined with their lower risk of mortality make life insurance uneconomic for non-smokers. This can exacerbate the adverse selection problem. As more smokers take out life insurance policies and increase the insurer's mortality rate, its prices will continue to rise, which in turn will mean fewer non-smokers will purchase insurance. Eventually, the higher prices will push out all non-smokers and the insurer will also be unwilling to sell to smokers. No more interactions will take place, and the life insurance market will collapse.
To counter the effects of adverse selection, insurers may offer premiums that are proportional to a customer's risk. The insurer screens customers to distinguish 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. 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 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.
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. 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. 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.
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 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, 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" .
This example assumes that the market does not know managers are selling stock. The market could possess this information, perhaps finding it in company reports. In this case, the market will capitalize on the information found in company reports. If the market has access to the company's information, there is no longer a state of adverse selection.
In contract theory
In modern contract theory, "adverse selection" characterizes principal-agent models in which an agent has private information 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, "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. 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 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.
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