What is Adverse Selection?

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Definition:

Adverse selection occurs when incomplete information leads you to pay or charge an amount that doesn't match an undisclosed risk.

🤔 Understanding adverse selection

Adverse selection stems from circumstances where a buyer or seller knows something the other party doesn't — which is called information asymmetry. Adverse selection often appears in insurance, where the provider cannot correctly price the associated risk into the premium because the client withholds some information about how much risk is actually present. The term comes from the idea that offering insurance naturally attracts people that are at higher risk. The self-selection process weeds out those that would be most profitable (ie, most unlikely to make a claim) and leaves those that are not. Hence, the process leads to a selection of adverse applicants. People now use the term to describe any situation that generates the opposite of the intended outcome, usually because of hidden information.

Example

Imagine you have a great business idea. You look at some data and conclude that only one in 100 people break the screen on their phone in a given year. You have the right tools and skills, so you know it would cost you $50 to repair a cracked screen. Rather than compete with other businesses that charge $100 per phone repair, you decide to take a different approach.

For $1 per year, a person can subscribe to have you replace their screen if it cracks. Your business model suggests that, on average, you will collect $100 per phone you have to fix ($1 from 100 people).

But there is a problem with your business plan. After a year, you realize that you ended up repairing ten times more screens than you planned. The problem was that the people willing to sign up for your plan were far more likely to need your service than the average person.

You fell victim to adverse selection.

Takeaway

Adverse selection is like offering free samples…

Imagine offering free samples of salmon jerky. Your goal is to get more customers by giving new people a taste. But, what if people that already like your product are the only ones willing to try it? Then you just gave away your product to people that were already going to buy it. Your target group was the non-customers; but, the people you attracted were from the wrong classification. That is adverse selection at work.

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How does adverse selection work?

Self-classification (placing yourself into a category or group) is a natural part of a capitalist economic system. And charging a different price for the different classifications of people is often a rational pricing strategy.

But, the process can lead to adverse selection when your different price points attract the wrong people. It mostly happens when people can place themselves in the wrong group by hiding something.

For example, if someone with a terminal illness gets life insurance without disclosing their prognosis, their selection of products is adverse. That is, they’re not selecting the product designed for their circumstance, and it results in the insurer’s costs being higher than expected.

The self-selection process of the market naturally separates people into different classifications – primarily, those that want your product and those that don't.

If you're selling cans of lima beans, it's not a big deal. Some people are your customers; others aren't. You can tell by observation who likes lima beans and who doesn't.

But, if you're selling insurance plans, the people that want your product are telling you something more important than what they enjoy.

For example, If you’re selling pet insurance, you can make a safe assumption that your customers have a furry friend. So, you better price your product based on what the average pet owner spends on pet care, not what the average of all households spend.

What is the difference between adverse selection and moral hazard?

While both phenomena expose an insurance company to more risk than they anticipated, the difference comes from how that additional risk arrives. With adverse selection, the risk is present, but hidden; whereas, with moral hazard, there is an increase in risk-taking because of the policy being in place.

People who display adverse selection are either intentionally or otherwise hiding some information from a provider, which then may enable them to pay less than they should. The risk is present when the insurance policy is written; however, if undiscovered, the company misprices the plan because it doesn't understand the actual amount of risk.

A moral hazard happens after the fact. It’s the idea that people change their behavior in response to shifting risk away from themselves. By becoming immune to the consequence of their actions, they end up taking more risks.

Some examples of moral hazard include a person becoming willing to go skydiving after a life insurance policy is issued. Or, it could even be a driver who’s ready to be more reckless because they trust the seatbelt and airbags to protect them physically and auto insurance to protect their finances.

What is adverse selection in health insurance?

Adverse selection frequently comes up in the United States health insurance market. The problem is mainly present in cafeteria-style health care plans — which allow the insured to choose from a menu of coverage options.

For example, imagine a dental plan that provides one option for $20 a month that only covers preventive care and another option for $200 per month that covers all dental expenses for the year.

Someone with excellent dental hygiene is likely to opt for the lower plan. Meanwhile, someone with aching teeth and known issues might see the $200 per month as a discount to what they expect to pay to the dentist.

Once this self-selection process is over, you end up with the low-cost plan attracting people that brush and floss daily and the high-cost plan full of people more likely to need expensive dental work.

Because the concentration of risk pushes up the number of payments that must be made, the insurance premium has to increase to cover those costs. But, that higher premium probably pushes people that were on the fence toward the lower plan. The pool shrinks again, the concentration of high-risk individuals increases, and premiums must rise.

What is adverse selection in the marketplace?

While adverse selection usually describes people placing themselves in the wrong insurance pool, often by way of deception, the term has been adopted in other markets as well. Most often, it describes asymmetric information during a negotiation between a seller and a buyer.

Imagine you’re in the market for a new television. You run across someone selling a TV on an online marketplace for $400. The ad says, "Brand new, never used. The retail price is $900." When you read this ad there’s a suspicion in the back of your mind that maybe something is wrong. When you go ahead and make the call, you learn that the seller is very motivated. They offer you an even better deal of $300.

All of a sudden, you’re even more convinced that this is a scam. By lowering the price, you became less interested. That is the opposite of how negotiating is supposed to work.

Because the buyer expects the seller to know more about the product, they rely on the price as a signal of quality. If the person is willing to part with it cheaply, they assume that the seller thinks it isn't worth much.

In some circles, this is called a lemon problem. But, extending the idea that adverse selection comes from hidden information, the term is regularly applied in the marketplace to describe this type of situation.

What is adverse selection in banking?

Many analysts now think that adverse selection in banking was one of the factors that contributed to the Great Recession.

In the years leading up to 2008, collateralized debt obligations (CDOs) began purchasing mortgages from lenders and reselling them as mortgage-backed securities (MBSs). By packaging many mortgages together, the CDO was designed to create high-quality financial securities out of lower-quality debts.

When the CDO offered to purchase whatever mortgages a lender was willing to sell, subprime loans went into the MBS while the highest-quality investments were more likely to stay with the original bank.

That was an adverse selection process, which ended up putting more risk into the MBSs than investors realized. When the housing bubble popped, it exposed the real value of those assets and led to a financial meltdown.

What is the solution to adverse selection?

Because adverse selection is mostly an information problem, transparency is part of the solution. In the health and life insurance industry, thorough vetting of applicants and pre-existing condition clauses help to reduce the ability of a policyholder to place themselves in the wrong pool.

With other insurance products, breaking down the classifications helps to spread risk over more people. Rather than having products that people select, the coverage extends to all of the insured. However, this can only work if participation is not optional. Otherwise, you end up only with participants that think they will use more than the cost of the insurance coverage.

Another solution is mandatory participation in an employee provided plan, including the healthy people that might not feel that they need it.

On a broader scale, the Affordable Care Act attempted to break the adverse selection process and reduce premiums. The idea was that broader participation would result in a lower cost everyone paid rather than allowing the self-selection process to drive people into high and low-cost options.

In banking, the Dodd-Frank Act and other financial reform laws were intended to reduce both adverse selection and moral hazard in the banking industry. The idea was to require people to keep some skin in the game. That way, if the deal went bad, there were consequences for the person that took the initial risk.

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The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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