Adverse Selection

1. IntroductionResearchers use several approaches to identify adverse selection.1 Genesove (1993) tests the proposition that, in a lemons market, prices inversely relate with observable seller characteristics that correlate with seller incentives to select goods adversely. Genesove examines the proposition in used automobile auctions. Chezum and Wimmer (1997) examine the proposition in thoroughbred racehorse markets, arguing that sellers with a high propensity to race horses should receive, on average, lower prices. Both Genesove (1993) and Chezum and Wimmer (1997) use data limited to market transactions. Wimmer and Chezum (2003) model adverse selection as a case of Heckman's (1979) sample selection bias and examine the correlation between errors in participation and price equations to study how third party certification could alleviate the effect of adverse selection in thoroughbred auctions.2In this paper, we extend the work of Genesove (1993) and Chezum and Wimmer (1997) and Wimmer and Chezum (2003) by characterizing adverse selection as a sample selection problem in a setting in which sellers possess (1) an informational advantage over buyers and (2) characteristics that correlate with both seller incentives to select goods adversely and the quality of goods produced. In such a setting, the relationship between prices and seller characteristics proves ambiguous, and researchers cannot easily disentangle adverse selection from quality effects. We show that Heckman's sample selection framework disentangles the correlation between a seller's characteristic and the effect of the selection decision on price from the correlation between a seller's characteristic and the quality of goods produced by a seller.The notion that the decision to sell goods relates to the quality of goods produced is not new. For example, Kim (1985) developed an adverse selection model in which car owners' maintenance and upkeep decisions affected the quality of used cars. Kim showed that allowing owners to affect the quality of goods could, under certain conditions, lead to an equilibrium in which the expected quality of used cars sold exceeds the expected quality of cars not sold. Similarly, we develop a theoretical model that extends a standard adverse selection specification by allowing owners (potential sellers) to improve a good's quality by expending unobserved effort. We show that owner effort only affects the adverse selection equilibrium when owners choose effort before they make the sell-retain decision.Owners decide whether to sell or retain a good once they observe their good's innate quality. Because buyers do not observe owner effort, the owner's dominant strategy is to expend zero effort on goods they will surely sell. Essentially, the model collapses to a standard moral hazard model, such as a fixed wage contract, in which employers cannot observe employee effort, and employees exert the necessary minimum effort to avoid dismissal. Because equilibrium effort equals zero, quality effects do not alter seller selection decisions and, therefore, the adverse selection equilibrium.Owners who must exert effort before they observe innate quality know only the probability that they will sell their goods and that the expected return to effort increases in the probability of retaining those goods. Because the probability of retention increases in seller incentives to select goods adversely, sellers who more likely select goods adversely also exert more effort. In this version of the model, no clear relationship exists between the expected quality of goods sold and the seller characteristics that Genesove (1993), and Chezum and Wimmer (1997) use to measure adverse selection. The model shows that uncertainty about whether a good will be sold partially solves the hidden action problem, in which owners underprovide effort and lessen the effect of adverse selection on markets.The notion that both adverse selection and moral hazard are important in markets affected by asymmetric information is well understood. …

The performance of five adverse selection models are examined by comparing their component estimates to other measures of information asymmetry and informed trading. The models produce mixed results. Adverse selection components correlate with various volatility measures, but appear unrelated to measures of uncertainty. Only three of the five models have the expected relation with informed trader proxies, suggesting that the adverse selection models measure adverse selection weakly at best. Spread also relates to many of the volatility measures, suggesting that some adverse selection components might be measuring some other cost of trading. One of the significant recent advancements in the market microstructure literature is the development of models that decompose the bid-ask spread into various components. In these models, the spread generally has three cost components: order processing, inventory holding, and adverse selection (or asymmetric information). Even though these microstructure models provide an important development in empirical finance, we know little about how well these models measure adverse selection and perform relative to each other. In the corporate finance literature, variables such as market-to-book, volatility, and institutional ownership are often used to measure the asymmetric information present in a stock. Recent papers also use adverse selection components as a direct measure of information problems. 1 However, little is known about how well adverse selection components measure information asymmetries. In this paper, we test the performance of five commonly used methods of computing adverse selection components. To determine the usefulness of the adverse selection models in measuring information problems, the relation between adverse selection components and measures of information asymmetries and various proxies for the presence of informed traders are examined. As a benchmark for the analysis, we also examine the performance of spread as a measure of information asymmetry. Using a three-stage simultaneous equation framework, adverse selection models are found to relate inconsistently to the various information variables. The major determinant of adverse selection appears to be volatility. Other measures of information asymmetries, such as analyst forecast errors and market-to-book, are not related to adverse selection. The proxies for informed traders produce mixed results. Overall, the relation for four of the five models are similar to those

Incentivized salespeople are often responsible for CRM activities that focus not only on customer acquisition, but also maintenance activities that increase customer lifetime value. While incentives can induce effort on the incentivized tasks, a salesperson’s private information about customers may induce moral hazard by salespeople seeking to gain short-term compensation at the expense of the firm’s long run profitability. We investigate the dynamics in the effort--moral hazard tradeoff in response to multidimensional (acquisition and maintenance) performance incentives in the presence of private information. Using unique panel data on customer loan acquisition and repayments linked to salespeople from a microfinance bank, we detect evidence of salesperson private information. Acquisition incentives induce salesperson moral hazard leading to adverse customer selection, but maintenance incentives moderate it as salespeople recognize the negative effects of acquiring low quality customers on future payoffs. Critically, without the moderating effect of maintenance incentives, the adverse selection effect of acquisition incentives overwhelms the sales enhancing effort effects, clarifying the importance of multidimensional incentives in CRM-type settings. Reducing private information (through job transfers) hurts customer maintenance, but has greater impact on productivity by moderating adverse selection at acquisition. The paper also contributes to the recent literature on detecting and disentangling customer adverse selection and customer moral hazard (defaults) with a new identification strategy that exploits the time varying effects of salesperson incentives.

This paper proposes a spatial model of imperfect competition in markets with adverse or advantageous selection. The model shows that a reduction in competition exacerbates the inefficiency created by adverse selection but can ameliorate the inefficiency created by advantageous selection. However, reduced competition never corrects the inefficiency perfectly because it introduces an allocative inefficiency. By contrast, the inefficiency can be corrected perfectly through a corrective tax when there is perfect competition. Our results have implications for competition policy in credit and insurance markets, as they caution against viewing imperfect competition as a solution to the inefficiencies created by selection.

At many firms, incentivized salespeople with private information about customers are responsible for customer relationship management. Although incentives motivate sales performance, private information can induce moral hazard by salespeople to gain compensation at the expense of the firm. The authors investigate the sales performance–moral hazard trade-off in response to multidimensional performance (acquisition and maintenance) incentives in the presence of private information. Using unique panel data on customer loan acquisition and repayments linked to salespeople from a microfinance bank, the authors detect evidence of salesperson private information. Acquisition incentives induce salesperson moral hazard, leading to adverse customer selection, but maintenance incentives moderate it as salespeople recognize the negative effects of acquiring low-quality customers on future payoffs. Critically, without the moderating effect of maintenance incentives, the adverse selection effect of acquisition incentives overwhelms the sales-enhancing effects, clarifying the importance of multidimensional incentives for customer relationship management. Reducing private information (through job transfers) hurts customer maintenance but has greater impact on productivity by moderating adverse selection at acquisition. This article also contributes to the recent literature on detecting and disentangling customer adverse selection and customer moral hazard (defaults) with a new identification strategy that exploits the time-varying effects of salesperson incentives.

The role of adverse selection in schemes for the procurement of ecosystem services has been investigated by many who suggest that efficiency of these schemes is impaired by problems arising from adverse selection. However recent research on the UK Environmental Stewardship Scheme suggests that these types of procurement system may not be characterised by adverse selection but by what might be more appropriately labelled as “beneficial selection”. These results are based on the analysis of a simple theoretical model and the empirical implications are confirmed using econometric analysis. However it is also suggested that, even with beneficial selection, there will still remain systemic inefficiency arising from a continuing need for the payment of informational rents to the farmers participating in the scheme. This paper presents the analysis of a model that focuses on the Principal- Agent characteristics of this problem and sets out to investigate the tradeoffs that arise in designing ecosystem procurement mechanisms where payment of informational rents to participants can be used to increase overall efficiency. The impact of beneficial selection is carefully explored here, and we suggest implications for policy makers and empirical propositions to be tested using a suitable data set.

Asymmetric information plays an important role in markets and politics. When parties are asymmetrically informed and have misaligned preferences, they may be hurt by adverse selection. By contrast, if parties know that their preferences are aligned, they may benefit from advantageous selection. Using a laboratory experiment, we investigate the degree to which individuals account for adverse and advantageous selection. By comparing behavior in a game in which subjects are asymmetrically informed with behavior in a game where those same subjects are symmetrically uninformed, we find evidence that a significant fraction of subjects account for these selection effects. We find that removing strategic uncertainty significantly increases the fraction of subjects who account for selection effects. Across our treatments, we find that subjects account for adverse selection to a greater degree than they account for advantageous selection. In addition, we find that a sizable fraction of subjects who do not behave according to predictions are in fact able to understand selection effects but do not apply that knowledge.

This paper studies risk selection between public and private health insurance when some, but not all, individuals can opt out of otherwise mandatory public insurance. Using a theoretical model, I show that public insurance is adversely selected when insurers and insureds are symmetrically informed about health-related risks, and that there can be adverse or advantageous selection when insureds are privately informed. Using data from the German Socio-Economic Panel, I find that (i) public insurance is, on balance, adversely selected under the German public health insurance with opt out scheme, (ii) individuals advantageously select public insurance based on risk aversion and residential location, and (iii) there is suggestive evidence of asymmetric information in the market for private health insurance. Copyright © 2016 John Wiley & Sons, Ltd.

A test on adverse selection of farmers in crop insurance: Results from Inner Mongolia, China

We develop a test for adverse selection and use it to examine private health insurance markets. In contrast to earlier papers that consider a purely private system or a system in which private insurance supplements a public system, we focus our attention on a system where privately funded health care is substitutive of the publicly funded one. Using a model of competition among insurers, we generate predictions about the correlation between risk and the probability of taking private insurance under both symmetric information and adverse selection. These predictions constitute the basis for our adverse selection test. The theoretical model is also useful to conclude that the setting that we focus on is especially attractive to test for adverse selection. Using the British Household Panel Survey, we find evidence that adverse selection is present in this market.

Previous articleNext article No AccessCompetition with Hidden KnowledgeJohn G. RileyJohn G. Riley Search for more articles by this author PDFPDF PLUS Add to favoritesDownload CitationTrack CitationsPermissionsReprints Share onFacebookTwitterLinkedInRedditEmail SectionsMoreDetailsFiguresReferencesCited by Journal of Political Economy Volume 93, Number 5Oct., 1985 Article DOIhttps://doi.org/10.1086/261344 Views: 9Total views on this site Citations: 38Citations are reported from Crossref Copyright 1985 The University of ChicagoPDF download Crossref reports the following articles citing this article:Ivija Bernatović, Alenka Slavec Gomezel, Matej Černe Mapping the knowledge-hiding field and its future prospects: a bibliometric co-citation, co-word, and coupling analysis, Knowledge Management Research & Practice 20, no.33 (Jun 2021): 394–409.https://doi.org/10.1080/14778238.2021.1945963Stephen Fox, Adrian Kotelba Organizational Neuroscience of Industrial Adaptive Behavior, Behavioral Sciences 12, no.55 (May 2022): 131.https://doi.org/10.3390/bs12050131Andrea Attar, Thomas Mariotti, François Salanié Entry-Proofness and Discriminatory Pricing under Adverse Selection, American Economic Review 111, no.88 (Aug 2021): 2623–2659.https://doi.org/10.1257/aer.20190189Andrea Attar, Thomas Mariotti, François Salanié Concurrence non exclusive et sélection adverse, Revue économique Vol. 69, no.66 (Nov 2018): 1009–1023.https://doi.org/10.3917/reco.696.1009John G. 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BackgroundAlthough most community-based health insurance (CBHI) schemes are voluntary, problem of adverse selection is hardly studied. Evidence on the impact of targeted subsidies on adverse selection is completely missing. This paper investigates adverse selection in a CBHI scheme in Burkina Faso. First, we studied the change in adverse selection over a period of 4 years. Second, we studied the effect of targeted subsidies on adverse selection.MethodsThe study area, covering 41 villages and 1 town, was divided into 33 clusters and CBHI was randomly offered to these clusters during 2004–06. In 2007, premium subsidies were offered to the poor households. The data was collected by a household panel survey 2004–2007 from randomly selected households in these 33 clusters (n = 6795). We applied fixed effect models.ResultsWe found weak evidence of adverse selection before the implementation of subsidies. Adverse selection significantly increased the next year and targeted subsidies largely explained this increase.ConclusionsAdverse selection is an important concern for any voluntary health insurance scheme. Targeted subsidies are often used as a tool to pursue the vision of universal coverage. At the same time targeted subsidies are also associated with increased adverse selection as found in this study. Therefore, it’s essential that targeted subsidies for poor (or other high-risk groups) must be accompanied with a sound plan to bridge the financial gap due to adverse selection so that these schemes can continue to serve these populations.

Most health insurers in the Netherlands apply community-rating and open enrolment for supplementary health insurance, although it is offered at a free market. Theoretically, this should result in adverse selection. There are four indications that adverse selection indeed has started to occur on the Dutch supplementary insurance market. The goal of this paper is to analyze whether premium differentiation would be able to counteract adverse selection. We do this by simulating the uptake and premium development of supplementary insurance over 25 years using data on healthcare expenses and background characteristics from 110,261 insured. For the simulation of adverse selection, it is assumed that only insured for whom supplementary insurance is expected not to be beneficial will consider opting out of the insurance. Therefore, we calculate for each insured the financial profitability (by making assumptions about the consumer’s expected claims and the premium set by the insurer), the individual’s risk attitude and the probability to opt out or opt in. The simulation results show that adverse selection might result in a substantial decline in insurance uptake. Additionally, the simulations show that if insurers were to differentiate their premium to 28 age and gender groups, adverse selection could be modestly counteracted. Finally, this paper shows that if insurers would apply highly refined risk-rating, adverse selection for this type of supplementary insurance could be counteracted completely.

This paper examines how car manufacturers use buyback prices in lease contracts to address problems of adverse selection in the secondary market. While theoretical work on adverse selection and leasing has largely focused on the automotive industry, empirical work has been limited to other industries (Gilligan, 2004). This paper builds on work from Desai and Purohit (1998, 1999), Hendel and Lizzeri (2002) and Johnson and Waldman (2003) to dissect the multiple considerations of the manufacturer in lease pricing. Using a rich dataset of 1 million new car transactions, I isolate the adverse selection effect through the contract relationship between the money factor, the residual value, and the monthly payment. This relationship allows the calculation of subsidization and buyback price adjustments jointly determining the contracted residual value. I then link this buyback adjustment to vehicle quality uncertainty, one of the primary determinants of adverse selection. This relationship is further identified through the use of vehicle warranties, which reduce adverse selection risk. I find evidence consistent with adverse selection considerations being an important part of vehicle lease pricing. This finding is unique in its examination of manufacturer behavior as consistent with predicted leasing responses to the adverse selection problem.

In this survey we present some of the more significant results in the literature on adverse selection in insurance markets. Sections 1 and 2 introduce the subject and Section 3 discusses the monopoly model developed by Stiglitz (1977) for the case of single-period contracts extended by many authors to the multi-period case. The introduction of multi-period contracts raises many issues that are discussed in detail; time horizon, discounting, commitment of the parties, contract renegotiation and accidents underreporting. Section 4 covers the literature on competitive contracts. The analysis is more complicated because insurance companies must take into account competitive pressures when they set incentive contracts. As pointed out by Rothschild and Stiglitz (1976), there is not necessarily a Cournot-Nash equilibrium in the presence of adverse selection. However, market equilibrium can be sustained when principals anticipate competitive reactions to their behavior or when they adopt strategies that differ from the pure Nash strategy. Multi-period contracting is discussed. We show that different predictions on the evolution of insurer profits over time can be obtained from different assumptions concerning the sharing of information between insurers about individual's choice of contracts and accident experience. The roles of commitment and renegotiation between the parties to the contract are important. Section 5 introduces models that consider moral hazard and adverse selection simultaneously and Section 6 covers adverse selection when people can choose their risk status. Section 7 discusses many extensions to the basic models such as risk categorization, multidimensional adverse selection, symmetric imperfect information, reversed or double-sided adverse selection, principals more informed than agents, uberrima fides and participating contracts.