Adverse selection

Sometimes the seller is the uninformed party instead, when consumers with undisclosed attributes purchase goods or contracts that are priced for other demographics.

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.

To counter the effects of adverse selection, insurers may require premiums that reflect the customer's risk, distinguishing high-risk from low-risk individuals.

Adverse selection can also result from government regulations prohibiting insurers from setting prices based on certain information.

[7] 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.

[8] To help prevent adverse selection, the ACA was designed with a risk adjustment programme to compensate insurers with sicker enrollees.

[16] Weak evidence of adverse selection in certain markets suggests that the underwriting process is effective at screening high-risk individuals.

Assuming that managers have inside information about the firm, outsiders are most prone to adverse selection in equity offers.

Outside investors, therefore, require a high rate of return on equity to compensate them for the risk of buying a "lemon".

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.

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).

Alternatively, models with interdependent or common values occur when the agent's type has a direct influence on the principal's preferences.

Banks have also implemented heavier screening on loan applicants so that they are receiving the full picture when they lend their money to borrowers.

Additionally, banks have implemented limits on lending for some borrowers to lower the risk of customers defaulting on their loan.

[30] 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.

Since adverse selection largely persists due to asymmetric information, the key steps to reducing its effects starts with eliminating said asymmetry by encouraging transparency between both sides of the market.

In markets where the seller has private information about the product they wish to sell, reputation mechanisms help to reduce adverse selection by acting as a signal of quality.

[36] Recognizing that adverse selection stems from the lack of information, using screening games allows players to try and analyse if the risk of the contract's worst possible outcome makes participating worth it in the first place.

For better context using the example of how adverse selection occurs in financial markets, if investors believe the risk of poor returns is too high, and the cost of consulting a trading specialist is not worth it, they have screened the possible outcomes and realize it is not worth making that initial investment from the start.

[36] Lemon laws act as a form of consumer protection in the event the buyer purchase a defective product.

This, in turn, reduces the problem of adverse selection, as buyers who are knowingly protected by lemon laws are more inclined to engage in transactions they previously would not have done so due to the lack of viable information available to them.

Those who are uncommitted to doing the regular upkeep of the house due to time constraints, are ill-prepared to compensate for damages, or just innately irresponsible, are more likely to rent.

These types of renters would then take advantage of the asymmetric information between the landlord, who would ideally want to lease the property to tenants without these characteristics.

In the latter case, however, it could be argued that there is no real issue of asymmetric information at play, given that the source of the behaviour change is a particular incentive structure which all parties are aware of.

In accordance with the research from Loannidou, Pavanini & Peng in April 2022, the adverse selection theory also plays a significant role in determining the lending market performance based on the incremental costs of collateral and debt contracts.

While the recent research also pointed out that, in separation of ex ante and ex post channels of collateral, the increasing level of adverse selection moral problem is having significant effects on bond markets and lenders' spirit.

While the empirical evidences and statistical model both suggested that, the utilization of collateral could reduce the negative effect of adverse selection.

In practice, through the promotion of information sharing system and credit rating mechanism, it is expected that, within the lending market regulations on collateral contact, the relevant stakeholder could have better incentives and techniques to reduce the social welfare cost that is cause by adverse selection.

In the acquisition of commercial mortgages between the sellers and borrowers, the adverse selection problem will appear corresponding with the phenomenon of asymmetric information.

To sum up, although the agency problem does not appears in junk loans and bonds, it still add the dissatisfied opinion on investor's behaviours.