Recognizing and Avoiding Adverse Selection: Looking at Examples

 Adverse selection is a concept that should be considered when developing any risk management plan. Although most commonly associated with insurance, it can creep into many projects and processes. But what is adverse selection and how can you deal with it?

Adverse selection refers to an event in which one party in a negotiation has relevant information about the situation that the other party lacks, and that asymmetry of information leads to a series of bad decisions or choices -- such as doing more and more business with less profitable or riskier market segments. The term “negotiation” can mean many things as used here, but it is often used to refer to the exchange of goods and services, with the buyer and the seller being the two parties described in the definition. To better illustrate this concept, we’ll look at a couple of examples.

 By far, the most common example used to illustrate adverse selection is in the insurance industry. In an ideal world, everyone who wanted to purchase insurance would carry the same risk of actually making a claim on the policy. That is, the seller and the buyer would both benefit from all transactions – the insurance company by assigning the right price to the policy and the insurance buyer by paying the appropriate amount for the policy.

In the real world, this is definitely not the case. Instead, the insurer would prefer to sell insurance to those customers who are least likely to make claims and, thus, “use” the insurance. Buyers, on the other hand, are generally more eager to purchase a policy if they believe they will have a need to make a claim.

Adverse selection can also be seen in some scenarios involving the hiring of independent contractors to perform certain types of work. For example, suppose that a landlord owns a number of rental properties and wants to hire someone to mow the lawns and do general yard maintenance for the properties. In this case, further assume that the landlord has decided on a predetermined amount that he is willing to pay per property for this work, and this amount is well below current market value.

The landlord advertises the job and it is accepted by a contractor with very little discussion on exactly what work should be performed. The landlord is expecting a very high quality job to be done, and each yard to be meticulously cared for. Based on the payment being offered, however, the contractor assumes that the landlord only wants minimal yard work done and only provides basic service.

 One of the biggest problems with adverse selection is that if it goes unrecognized or if it is not accounted for in some way, it can quickly spiral into a situation that gets progressively worse and worse.

For instance, in the insurance example, if the insurer doesn’t figure out a way to group similar risks and charge each group accordingly, the product will be priced in such a way that it is only attractive to “bad” risks. This, in turn, will make the product unprofitable and may lead the insurance company to try to fix the problem by raising rates. But, in this case, raising rates will just make the problem worse – making it so that the product only looks like a good deal to even worse risks that are unable to purchase insurance from other sources. If the insurer continues this cycle, it will soon be left with nothing but a “bad” book of business – the complete opposite of its true goal.

In the second example involving the landlord and the independent contractor, a similar problem might occur. Since the landlord isn’t willing to pay the market rate for quality lawn care, he’s only likely to attract contractors that are either unable or unwilling to provide the level of quality work that is being expected. As a result, the rental properties may start to generate less income since they are less attractive to prospective renters. Since the landlord’s income is decreasing, he may decide to spend even less than before on property upkeep, perpetuating the cycle even further.

Because of its very nature, adverse selection can be tough to recognize and even tougher to blame as the root cause of a problem. Even if adverse selection is suspected as an underlying cause, trying to figure out a way to combat it can be very challenging. In fact, as shown in the insurance example, it may be impossible to get rid of adverse selection entirely in some cases – the only hope may be to minimize it as much as possible while still being aware that the negative risk exists.

Experiment 2: Adverse Selection, http://www.econ.ucsb.edu/~tedb/Courses/Ec100C/lemonsexperiment.pdf

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1. Poor Eyesight, sxc.hu/chidsey

2. Wrecked Car, sxc.hu/darius9000

3. Traffic Lights, sxc.hu/borodoa003