Editing Adverse selection (section)

== Examples ==
===Insurance===
Adverse selection was first described for life insurance. It creates a demand for insurance which is positively correlated with the insured's risk of loss.<ref name="railway times" />

For example, overall, non-smokers have a much lower risk of death than smokers of the same age and sex. If the price of insurance does not vary according to smoking status, then it will be more valuable for smokers than for non-smokers. Thus smokers will have a greater incentive to buy insurance and will purchase more insurance than non-smokers. This increases the average mortality rate of the insured pool, causing the insurer to pay more claims. The insurer relies on the premiums of the healthy non-smokers to cover the costs incurred by the smokers. As more smokers purchase insurance, costs to insure them increases.<ref>{{cite journal |last1=O'Neill |first1=Siobhan |last2=Posada-Villa |first2=Jose |last3=Medina-Mora |first3=Maria Elena |last4=Al-Hamzawi |first4=Ali Obaid |last5=Piazza |first5=Marina |last6=Tachimori |first6=Hisateru |last7=Hu |first7=Chiyi |last8=Lim |first8=Carmen |last9=Bruffaerts |first9=Ronny |last10=Lépine |first10=Jean-Pierre |last11=Matschinger |first11=Herbert |last12=de Girolamo |first12=Giovanni |last13=de Jonge |first13=Peter |last14=Alonso |first14=Jordi |last15=Caldas-de-Almeida |first15=Jose Miguel |last16=Florescu |first16=Silvia |last17=Kiejna |first17=Andrzej |last18=Levinson |first18=Daphna |last19=Kessler |first19=Ronald C. |last20=Scott |first20=Kate M. |title=Associations between DSM-IV mental disorders and subsequent self-reported diagnosis of cancer |journal=Journal of Psychosomatic Research |date=March 2014 |volume=76 |issue=3 |pages=207–212 |doi=10.1016/j.jpsychores.2013.12.012 |pmid=24529039 |pmc=5129659 }}</ref>

In response, the company may increase premiums to correspond to the higher average risk. However, higher prices cause rational non-smokers to cancel their insurance as insurance becomes uneconomic for them, exacerbating the adverse selection problem. Eventually, higher prices will push out all non-smokers in search of better options, and the only people left who will be willing to purchase insurance are smokers.<ref>{{cite journal |last1=Kerschbamer |first1=Rudolf |last2=Neururer |first2=Daniel |last3=Sutter |first3=Matthias |title=Insurance coverage of customers induces dishonesty of sellers in markets for credence goods |journal=Proceedings of the National Academy of Sciences |date=5 July 2016 |volume=113 |issue=27 |pages=7454–7458 |doi=10.1073/pnas.1518015113 |pmid=27325784 |pmc=4941439 |bibcode=2016PNAS..113.7454K |doi-access=free }}</ref> The same applies to health insurance.

To counter the effects of adverse selection, insurers may require premiums that reflect the customer's risk, distinguishing high-risk 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 unacceptably high-risk individuals are rejected (''cf.'' [[pre-existing condition]]). This risk selection process is 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.

Adverse selection can also result from government regulations prohibiting insurers from setting prices based on certain information. This is sometimes referred to as "regulatory adverse selection".<ref>{{cite journal |last1=Polborn |first1=Mattias K. |last2=Hoy |first2=Michael |last3=Sadanand |first3=Asha |title=Advantageous Effects of Regulatory Adverse Selection in the Life Insurance Market |journal=The Economic Journal |date=1 January 2006 |volume=116 |issue=508 |pages=327–354 |doi=10.1111/j.1468-0297.2006.01059.x |s2cid=154501669 |doi-access= }}</ref> For instance, the US government enacted the Affordable Care Act (ACA) which prohibits insurers from charging higher prices based on pre-existing conditions and gender.<ref name=":0">{{cite journal |last1=Orentlicher |first1=David |title=Cost Containment and the Patient Protection and Affordable Care Act |journal=FIU Law Review |date=22 September 2010 |volume=6 |issue=1 |doi=10.25148/lawrev.6.1.7 |doi-access=free |url=https://scholars.law.unlv.edu/cgi/viewcontent.cgi?article=2103&context=facpub }}</ref> To help prevent adverse selection, the ACA was designed with a risk adjustment programme to compensate insurers with sicker enrollees.<ref>{{cite journal |last1=Kautter |first1=John |last2=Pope |first2=Gregory |last3=Keenan |first3=Patricia |title=Affordable Care Act Risk Adjustment: Overview, Context, and Challenges |journal=Medicare |date=2014 |volume=4 |issue=3 |pages=E1–E11 |doi=10.5600/mmrr.004.03.a02 |pmc=4214269 |pmid=25364625 }}</ref> The ACA also required US residents to enroll in healthcare coverage or pay a tax penalty. This was in place to ensure enrollment by healthy individuals, even though they are less likely to claim and thus they may not otherwise have considered the coverage to be financially worthwhile.<ref name=":0" />

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,<ref>{{cite journal |last1=Cawley |first1=J. |last2=Philipson |first2=T. |title=An Empirical Examination of Barriers to Trade in Insurance |journal=[[American Economic Review]] |volume=89 |issue=4 |year=1999 |pages=827–846 |jstor=117161 |doi=10.1257/aer.89.4.827|s2cid=153756802 |url=http://www.nber.org/papers/w5669.pdf }}</ref> auto insurance,<ref>{{cite journal |last1=Chiappori |first1=P. A. |last2=Salanie |first2=B. |year=2000 |title=Testing for Asymmetric Information in Insurance Markets |journal=[[Journal of Political Economy]] |volume=108 |issue=1 |pages=56–78 |doi=10.1086/262111 |citeseerx=10.1.1.470.5388 |s2cid=55976555 }}</ref><ref>{{cite journal |last1=Dionne |first1=G. |last2=Gouriéroux |first2=C. |last3=Vanasse |first3=C. |year=2001 |title=Testing for Evidence of Adverse Selection in the Automobile Insurance Market: A Comment |journal=Journal of Political Economy |volume=109 |issue=2 |pages=444–453 |doi=10.1086/319557 |s2cid=154681165 }}</ref> and health insurance.<ref>{{cite journal |last1=Cardon |first1=J. H. |last2=Hendel |first2=I. |title=Asymmetric information in health insurance: evidence from the National Medical Expenditure Survey |year=2001 |journal=RAND Journal of Economics |volume=32 |issue=3 |pages=408–427 |jstor=2696362 |pmid=11800005 |s2cid=23645181 }}</ref>  On the other hand, "positive" test results for adverse selection have been reported in health insurance,<ref>{{cite journal |last1=Cutler |first1=David M. |last2=Zeckhauser |first2=Richard J. |title=Adverse Selection in Health Insurance |journal=Forum for Health Economics & Policy |date=1 January 1998 |volume=1 |issue=1 |doi=10.2202/1558-9544.1056 |url=http://www.nber.org/papers/w6107.pdf }}</ref> long-term care insurance,<ref>{{cite journal |last1=Finkelstein |first1=A. |last2=McGarry |first2=K. |year=2006 |doi=10.1257/aer.96.4.938 |title=Multiple dimensions of private information: evidence from the long-term care insurance market |journal=American Economic Review |volume=96 |issue=4 |pages=938–958 |pmc=3022330 |jstor=30034325 |pmid=21253439}}</ref> and annuity markets.<ref>{{cite journal |last1=Finkelstein |first1=A. |last2=Poterba |first2=J. |doi=10.1086/379936 |title=Adverse selection in insurance markets: policyholder evidence from the UK annuity market |journal=Journal of Political Economy |volume=112 |issue=1 |year=2004 |pages=183–208 |s2cid=14608232 |url=http://www.nber.org/papers/w8045.pdf }}</ref>

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.<ref>{{cite journal|last=Hemenway|first=D.|year=1990|title=Propitious selection|journal=[[Quarterly Journal of Economics]]|volume=105|issue=4|pages=1063–1069|doi=10.2307/2937886|jstor=2937886|doi-access=free}}</ref><ref>{{cite journal|last1=De Meza|first1=D.|last2=Webb|first2=D. C.|s2cid=55494801|year=2001|title=Advantageous selection in insurance markets|journal=RAND Journal of Economics|volume=32|issue=2|pages=249–262|jstor=2696408}}</ref> This occurs when a person is both less likely to engage in risk-increasing behaviour are more likely to engage in risk-decreasing behaviour, 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.<ref>{{cite journal |last1=Viscusi |first1=W. K. |last2=Hersch |first2=J. |doi=10.1162/00346530151143806 |title=Cigarette smokers as job risk takers |journal=Review of Economics and Statistics |volume=83 |issue=2 |year=2001 |pages=269–280 |hdl=1803/6284 |s2cid=14973680 |hdl-access=free }}</ref>  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.<ref>{{cite journal |last=Thomas |first=R. G. |year=2008 |title=Loss coverage as a public policy objective for risk classification schemes |journal=Journal of Risk & Insurance |volume=75 |issue=4 |pages=997–1018 |doi=10.1111/j.1539-6975.2008.00294.x |citeseerx=10.1.1.554.1037 |s2cid=53647253 }}</ref>

=== 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, this acts as a signal to outside investors that the firm's management believes the current stock price is undervalued, as the firm 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 theory|pecking order]]".<ref>{{cite journal|title = Corporate financing and investment decisions when firms have information that investors do not have|doi=10.1016/0304-405X(84)90023-0|volume=13|issue = 2|journal=Journal of Financial Economics|pages=187–221|year = 1984|last1 = Myers|first1 = Stewart C.|last2 = Majluf|first2 = Nicholas S.|hdl = 1721.1/2068|url=http://www.nber.org/papers/w1396.pdf |hdl-access = free}}</ref>

The example described assumes that the market does not know managers are selling stock. The market could gain access to this information, perhaps by finding it in company reports. In this case, the market will capitalize on the information found. If the market has access to the company's information, the presence of information asymmetry is removed, and as such there is no longer a state of adverse selection.

The presence of adverse selection in capital markets results in excessive private investment. Projects that otherwise would not have received investments due to having a lower expected return than the [[opportunity cost]] of capital, received funding as a result of information asymmetry in the market. As such, governments must account for the presence of adverse selection in the implementation of public policies.<ref>{{cite journal |last1=Braido |first1=Luis H. B. |last2=da Costa |first2=Carlos E. |last3=Dahlby |first3=Bev |title=Adverse Selection and Risk Aversion in Capital Markets |journal=FinanzArchiv |date=2011 |volume=67 |issue=4 |pages=303–326 |doi=10.1628/001522111X614141 |jstor=41472630 |url=https://sites.ualberta.ca/~econwps/2009/wp2009-15.pdf }}</ref>

=== Contract theory ===
{{main|Principal–agent problem}}
In modern [[contract theory]], "adverse selection" characterizes principal-agent models in which an agent has [[private information]] ''before'' a contract is written.<ref>{{Cite book|title = The theory of incentives: The principal-agent model|last1 = Laffont|first1 = Jean Jacques|publisher = Princeton University Press|year = 2002|last2 = Martimort|first2 = David}}</ref><ref>{{Cite book|title = Contract theory|last1 = Bolton|first1 = Patrick|publisher = MIT Press|year = 2005|last2 = Dewatripont|first2 = Matthias}}</ref> 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.<ref>{{cite book |last1=Hart |first1=Oliver |last2=Holmström |first2=Bengt |chapter=The theory of contracts |pages=71–155 |chapter-url=https://books.google.com/books?id=8os5AAAAIAAJ&pg=PA71 |editor1-last=Bewley |editor1-first=Truman F. |title=Advances in Economic Theory: Fifth World Congress |date=1989 |publisher=CUP Archive |isbn=978-0-521-38925-9 }}</ref> 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.

In most adverse selection models, it is assumed that the agent's private information is "soft" (i.e., the information cannot be certified). Yet, there are also some adverse selection models with "hard" information (i.e., the agent may have evidence to prove that claims he makes about his type are true).<ref>{{cite journal |last1=Schmitz |first1=Patrick W. |title=Contracting under adverse selection: Certifiable vs. uncertifiable information |journal=Journal of Economic Behavior & Organization |date=February 2021 |volume=182 |pages=100–112 |doi=10.1016/j.jebo.2020.11.038 |doi-access=free |url=https://mpra.ub.uni-muenchen.de/105106/1/MPRA_paper_105106.pdf }}</ref>

Adverse selection models can be further categorized into 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|Myerson-Satterthwaite theorem]].<ref>{{cite journal |last1=Myerson |first1=Roger B |last2=Satterthwaite |first2=Mark A |title=Efficient mechanisms for bilateral trading |journal=Journal of Economic Theory |date=April 1983 |volume=29 |issue=2 |pages=265–281 |doi=10.1016/0022-0531(83)90048-0 |hdl=10419/220829 |url=http://www.kellogg.northwestern.edu/research/math/papers/469.pdf |hdl-access=free }}</ref> More recently, contract-theoretic adverse selection models have been tested both in laboratory experiments and in the field.<ref>{{Cite journal|title = Do sellers offer menus of contracts to separate buyer types? An experimental test of adverse selection theory|journal = Games and Economic Behavior|date = 2015|pages = 17–33|volume = 89|doi = 10.1016/j.geb.2014.11.001|first1 = Eva I.|last1 = Hoppe|first2 = Patrick W.|last2 = Schmitz|doi-access = free}}</ref><ref>{{Cite SSRN |title = Testing Contract Theory: A Survey of Some Recent Work|ssrn = 318780|date = 2002 |first1 = Pierre-Andre|last1 = Chiappori|first2 = Bernard|last2 = Salanie}}</ref>

===Banking===
When banks and borrowers come together to determine the personal loans, mortgages or business loans, adverse selection is deeply rooted in the discussions.<ref name=Marquez2002>{{cite journal |last1=Marquez |first1=Robert |title=Competition, Adverse Selection, and Information Dispersion in the Banking Industry |journal=The Review of Financial Studies |date=2002 |volume=15 |issue=3 |pages=901–926 |doi=10.1093/rfs/15.3.901 |jstor=2696725}}</ref>

For example, when a new customer approaches a bank seeking a [[personal loan]], they will always know their spending, saving and potential income better than the bank would. This creates adverse selection as the customer possess information about their life which is unknown to the bank, and they can take an economic advantage due to this information.<ref>{{cite journal |last1=Dong |first1=Baomin |last2=Guo |first2=Guixia |title=The relationship banking paradox: No pain no gain versus raison d'être |journal=Economic Modelling |date=2011 |volume=28 |issue=5 |page=2263 |doi=10.1016/j.econmod.2011.06.009}}</ref>

Similarly, when a business requests a loan from a bank, this also creates adverse selection. The business possesses information about market trends, insider business knowledge, and other future happenings relevant to the business that a bank would not know when lending money to a company. 

A further case where adverse selection is relevant is when banks trade loans. This process creates adverse selection, as when a bank transfers a loan to a new bank, they are unaware of how risky the borrower is and the other associated risks that go along with banks lending their money.<ref>{{cite journal |last1=Chari |first1=V. V. |last2=Shourideh |first2=Ali |last3=Zetlin-Jones |first3=Ariel |title=Reputation and Persistence of Adverse Selection in Secondary Loan Markets |journal=American Economic Review |date=1 December 2014 |volume=104 |issue=12 |pages=4027–4070 |id={{ProQuest|1629675912}} |doi=10.1257/aer.104.12.4027 |url=http://www.aeaweb.org/aer/app/10412/20110580_app.pdf }}</ref>

To counteract the effects of adverse selection, banks have moved towards building stronger relationships with their customers, to assist in further understanding some of the hidden information the consumers have when they are borrowing from banks. Furthermore, banks can adjust interest rates to help alleviate some of they unknown risks involved. Banks have also implemented heavier screening on loan applicants so that they are receiving the full picture when they lend their money to borrowers. They are investing significant amounts of resources to gather enough information on borrowers to help estimate the possibility of the loan being repaid by the borrower. Additionally, banks have implemented limits on lending for some borrowers to lower the risk of customers defaulting on their loan.<ref name=Marquez2002/>

Banks have been trying to implement as many safeguards as possible on the borrowing process to try to limit the effects of adverse selection on their business.