Adverse selection

Adverse selection

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Adverse selection, anti-selection, or negative selection is a term used in economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

, insurance
Insurance
In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...

, statistics
Statistics
Statistics is the study of the collection, organization, analysis, and interpretation of data. It deals with all aspects of this, including the planning of data collection in terms of the design of surveys and experiments....

, and risk management
Risk management
Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities...

. 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 services 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
Insurance
In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...

. 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. This may be because of private information known only to the individual (information asymmetry
Information asymmetry
In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry, a kind of market failure...

), 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'.

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
Underwriting
Underwriting refers to the process that a large financial service provider uses to assess the eligibility of a customer to receive their products . The name derives from the Lloyd's of London insurance market...

. In many countries, insurance law incorporates an 'utmost good faith' or uberrima fides
Uberrima fides
Uberrima fides is a Latin phrase meaning "utmost good faith" . It is the name of a legal doctrine which governs insurance contracts. This means that all parties to an insurance contract must deal in good faith, making a full declaration of all material facts in the insurance proposal...

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, 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 (e.g. between mortality and whether the customer chooses a life annuity
Life annuity
A life annuity is a financial contract in the form of an insurance product according to which a seller — typically a financial institution such as a life insurance company — makes a series of future payments to a buyer in exchange for the immediate payment of a lump sum or a series...

 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
Underwriting
Underwriting refers to the process that a large financial service provider uses to assess the eligibility of a customer to receive their products . The name derives from the Lloyd's of London insurance market...

 is largely effective. Another possible reason is negative correlation between risk aversion
Risk aversion
Risk aversion is a concept in psychology, economics, and finance, based on the behavior of humans while exposed to uncertainty....

 (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. 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.

In studies of health insurance, an individual mandate
Individual mandate
An individual mandate is a requirement by a government that certain individual citizens purchase or otherwise obtain a good or service.In the United States, the United States Congress has enacted two individual mandates, the first was never federally enforced, while the second is not scheduled to...

 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
Risk pool
A risk pool is one of the forms of risk management mostly practiced by insurance companies. Under this system, insurance companies come together to form a pool, which can provide protection to insurance companies against catastrophic risks such as floods, earthquakes etc. The term is also used...

. Mandates, like all insurance, increase moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...

.

See also

  • Information asymmetry
    Information asymmetry
    In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry, a kind of market failure...

  • Community rating
    Community rating
    Community rating is a concept usually associated with health insurance, which requires health insurance providers to offer health insurance policies within a given territory at the same price to all persons without medical underwriting, regardless of their health status.Pure community rating...

  • Moral hazard
    Moral hazard
    In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...

  • Agency cost
    Agency cost
    An agency cost is an economic concept that relates to the cost incurred by an entity associated with problems such as divergent management-shareholder objectives and information asymmetry...

  • Principal–agent problem
  • Contract theory
    Contract theory
    In economics, contract theory studies how economic actors can and do construct contractual arrangements, generally in the presence of asymmetric information. Because of its connections with both agency and incentives, contract theory is often categorized within a field known as Law and economics...

  • Death spiral (insurance)
    Death spiral (insurance)
    Death spiral is a term used to describe an insurance plan whose costs are rapidly increasing as a result of changes in the covered population. It is the result of adverse selection in insurance policies where lower risk policy holders choose to change policies or be uninsured...

  • Market for Lemons

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