Adverse Selection – a definition, some examples, and some solutions

The adverse selection problem (also known as the “hidden information” problem) is especially easy to grasp in an insurance market setting; if you are an insurer, you need to be concerned that the worst potential risks may be those wishing to purchase insurance. However, it is important to note that adverse selection also occurs in many other market settings. Adverse selection occurs whenever one party has superior information compared with his or her counterparty. When this occurs, there is a risk that the more informed party may take advantage of the other, less informed party.

In an insurance setting, adverse selection is an issue whenever insurers know less about the actual risk characteristics of a potential client than the client herself.  Banks have limited information about their potential clients’ willingness and ability to pay back their loan commitments in lending markets. In the used car market, the used car seller has more information about the car for sale than potential buyers. In the labor market, employers typically know less than the worker does about his or her abilities. In product markets, the product’s manufacturer often knows more about product failure rates than the consumer, and so forth…

If left unchecked, adverse selection can undermine the ability of firms and consumers to enter into contractual relationships and, in extreme cases, may even give rise to so-called market failures. For example, since the seller has more information than the buyer about the vehicle’s condition in the used car market, the buyer cannot help but be suspicious about product quality. Thus, she may not be willing to pay as much for the car as it is worth (assuming it is not a “lemon”). Similarly, insurers may be reticent about selling policies to bad risks, banks may be worried about loaning money to poor credit risks, employers may be concerned about hiring poor-quality workers, consumers may be worried about buying poor-quality products, and so on…

Several strategies exist for mitigating adverse selection. In financial services markets, risk classification represents an important strategy. Insurers and banks want to know your credit score because consumers with bad credit often lack the willingness and ability to pay their debts and have more accidents on average than consumers with good credit. Signaling is used in various settings; for example, one solution to the “lemons” problem in the market for used cars is for the seller to “signal” by providing credible third-party certification; e.g., by paying for Carfax reports or relying on vehicle inspections by an independent third-party intermediary such as Carmax. Students “signal” their quality by selecting a high-quality university (e.g., Baylor! :-)). Here, the university provides potential employers with credible third-party certification concerning the quality of human capital. In product markets, if a manufacturer provides a long-term warranty, this may signal that quality is better than average.

Sometimes, mitigating fully adverse selection via the methods described above is impossible. Thus, insurers commonly employ pricing and contract design strategies that financially reward policyholders for revealing their true risk characteristics according to their contract choices; i.e., they voluntarily reveal their preferences. Thus, we get what’s commonly referred to as a “separating” (Rothschild-Stiglitz) equilibrium in which high-risk insureds select full coverage “high-risk” contracts whereas low-risk insureds select partial coverage “low-risk” contracts:


The Rothschild-Stiglitz equilibrium cleverly restricts the menu of choices in such a way that the insurer induces self-selection; i.e., low-risk insureds select the (low-risk and profitable) partial coverage contract designed with them in mind, and the high-risk insureds select the (high-risk and profitable) full coverage contract designed for them.  Here, the insurer offers contract L, which involves partial coverage at an actuarially fair price (based on the loss probability of the low-risk insured), and contract H, which provides full coverage at an actuarially fair price (based on the loss probability of the high risk insured). The indifference curve slopes are steeper for the low-risk insureds than they are for the high-risk insureds.  Here, the high-risk policyholder optimally chooses contract H, and the low-risk policyholder optimally chooses contract L. The high-risk policyholder prefers H to L because L would represent a point of intersection with a marginally lower indifference curve (here, the Ih curve lies slightly above contract L, which implies that contract H provides the high-risk policyholder with higher expected utility than contract L).  The low-risk policyholder prefers L to H, even though only provides partial coverage.   Thus, one inefficiency related to adverse selection is that insurance opportunities available to low-risk policyholders are limited compared with the world where there is no adverse selection.

This model has very practical implications. If you are a good risk, then you owe it to yourself to select high-deductible insurance since insurers price low-deductible insurance, expecting high-risk policyholders will be the primary purchasers of such coverage (and therefore, low-deductible policies will be more costly per dollar of coverage than high-deductible policies).

On the Determinants of Risk Aversion

Several years ago, The Economist published a particularly interesting article about various behavioral determinants of risk aversion, entitled “Risk off: Why some people are more cautious with their finances than others”. Here are some key takeaways from this (somewhat dated, but still quite timely) article:

  1. Economists have long known that people are risk averse, yet the willingness to run risks varies enormously among individuals and over time.
  2. Genetics explains a third of the difference in risk-taking; e.g., a Swedish study of twins finds that identical twins had “… a closer propensity to invest in shares” than fraternal ones.
  3. Upbringing, environment, and experience also matter; e.g., “… the educated and the rich are more daring financially. So are men, but apparently not for genetic reasons.”
  4. People’s financial history has a strong impact on their taste for risk; e.g., “… people who experienced high (low) returns on the stock market earlier in life were, years later, likelier to report a higher (lower) tolerance for risk, to own (not own) shares and to invest a bigger (smaller) slice of their assets in shares.”
  5. “Exposure to economic turmoil appears to dampen people’s appetite for risk irrespective of their personal financial losses.” Furthermore, low tolerance for risk is linked to past emotional trauma.

Some important intuitions from yesterday Finance 4335 class meeting…

  1. The most important concept covered in class yesterday is that people vary in terms of their preferences for bearing risk. Although we focused most of our attention on modeling risk-averse behavior, we also briefly considered examples of risk neutrality (where you only care about expected wealth and are indifferent about the riskiness of wealth) and risk loving (where you prefer to bear risk and are willing to pay money for the opportunity to do so).
  2. Related to point 1: irrespective of whether you are risk averse, risk neutral, or risk loving, the foundation for decision-making under conditions of risk and uncertainty is expected utility. Given a choice among various risky alternatives, one selects the choice that has the highest utility ranking.
  3. If you are risk averse, then E(W) > {W_{CE}} and the difference between E(W) and {W_{CE}} is equal to the risk premium \lambda. Some practical implications — if you are risk averse, then you are okay with buying “expensive” insurance at a price that exceeds the expected value of payment provided by the insurer, since (other things equal) you’d prefer to transfer risk to someone else if it’s not too expensive to do so. On the other hand, you are not willing to pay more than the certainty equivalent for a bet on a sporting event or a game of chance.
  4. If you are risk neutral, then E(W) = {W_{CE}} and \lambda = 0; risk is inconsequential and all you care about is maximizing the expected value of wealth.
  5. If you are risk loving, then E(W) < {W_{CE}} and \lambda < 0; you are quite willing to pay for the opportunity to (on average) lose money.