Adverse selection

For a more general discussion of health insurance markets, including the roles of moral hazard and adverse selection, see Cutler and Zeckhauser (2000). 

Private insurance markets do not work well if there is adverse selection, moral hazard, or inadequate population-level information about the insured risks. 

Adverse selection exists when individuals know more about their individual risks than do insurance companies. Under such circumstances, people compare their risks with the best premium offered by an insurance company. Those individuals whose risks are less than the premium will self-insure, leaving the company with above-average risks in its pool. An insurance company might realize this problem only after collected premiums do not cover subsequent claims. If a company then raises premiums, more individuals will opt to self-insure, the process will continue, and the eventual result will be no insurance policies. 

Insurance companies have developed several strategies to cope with the information difficulties that lead to moral hazard and adverse selection. They use deductibles and copayments to reduce moral hazard. If cusfomers musf pay some of fhe damage cosfs themselves when accidents occur, they are less likely to engage in unanticipated risky behavior. Some firms also use experience rafing (i.e., raising rates if a claim is made) to reduce moral hazard. Experience rating penalizes cautious clients who still suffer accidents, but insurance firms cannot economically differentiate those careful policyholders from morally hazardous ones. 

A common ex ante information strategy companies use to avoid adverse selection is to vary premiums according to demographic, geographic, and occupational categories. Rural drivers have fewer automobile accidents young males have more. Inner-city blacks experience more thefts than inner-city whites, even after controlling for income. 

Winter (1991) argues that unstable interest rates, unanticipated changes in tort liability rules, asymmetric information, adverse selection, and capital market inefficiencies all caused difficulties for fhe liability insurance market during the 1980s. 

Capital market inefficiencies exacerbate the problems caused by adverse selection. Because corporate income is doubly taxed, earnings are retained during good times rather than dispersed to shareholders. When the supply of insurance is tight and profits are high, external capital does not enter the industry in optimal amounts because, once it is in the corporate sector, capital is not easily transferred back to individuals without dividend taxation. Also, external and internal capital are not perfect substitutes because of the asymmetry of information. If investors believe the best financial opportunities are reserved for insiders, any attempt to raise public equity is a signal that few profits are available. 

Adverse Selection and Long-Term Hazards The Choice between Contract and Mandatory liabflity Rules. Journal of Legal Studies 21 (January) 189-215. 

If the main aim of the voucher scheme is to detect and treat a disease, to subsidize the poor, or both, adverse selection need not be a major concern. Indeed, it may represent an improvement in technical efficiency if those most at risk of a disease are most likely to use their voucher. Where diagnosis outside the voucher scheme is not reliable, adverse selection becomes less of a risk, because many of those seeking prepaid treatment may not actually have the disease and will therefore not require treatment (see box 7-2). 

The last ten years have witnessed a considerable growth in the number of publications that utilize techniques from economics in the study of production and operations system. A central tool in these studies is the principal-agent model which focused on problems of decentralization when there are information asymmetries when one party is better informed than a second party. However, most of the OM problems that are of considerable interest do not fit neatly into the principal-agent models utilized in economic theory. Specifically, most theoretical economic models assume that the information asymmetries are either of hidden action (moral hazard) or of hidden system parameters (adverse selection). Further, these models focus almost exclusively in static economic environments or very simplified dynamic environments. In real-life operational systems, information asymmetry cannot be neatly categorized as in the theoretical models, and the dynamic environment is, in general, complex and multifaceted. 

Production contracts do not only estabhsh selling and buying obligations but do also prescribe some details of the production process such as feed, breed or animal welfare aspects. Especially in markets with high information asymmetries, the contractor tries to control a munber of inputs in order to reduce the scope of moral hazard problems and adverse selection (Goodhue, 1999 617). 

Transaction Cost Economics (TCE) provides the most common theoretical framework for contracts and vertical integration in livestock production. Contracts may reduce moral hazard problems through centralized decisions about input factors (feed, genetic, etc.) and production standards. The problem of adverse selection in case of unobservable quality characteristics (credence attributes) is decreased by contract systems with inherent monitoring approaches. A long-term orientation could enhance the processors ability to introduce new technologies. 

The healthcare market is not perfect for many reasons including asymmetric information, adverse selection, moral hazard, and externalities. The patient (consumer) often does not know what medical services he/she may require, and does not know how to assess the quality of services provided. The supplier (providers) determines the services the patient needs (diagnostic and treatment). Therefore, unless it is a standard service, the information asymmetry inhibits the patient from shopping around for price and quality. The second reason is the insurance market -healthy people prefer not to buy health insurance (adverse selection), and insured patients may agree to uimecessary procedures because purchasing insurance decreases their price sensitivity to healthcare services (moral hazard). Finally, there is an externality effect in health care especially where infectious diseases are concerned - vaccinations of others benefit my health . This may lead to vaccination services being under-consumed. 

Two known issues in offering insurance coverage are moral hazard and adverse selection (note they are applicable to not only catastrophe earthquake but other more common types). Moral hazard refers to a case where more risky situations (i.e., increase in chances of experiencing loss and/or increase in the extent of loss) are created by the behavior of a stakeholder. An example of moral hazard is that a policyholder, after a damaging earthquake, may cause additional damage to his/her property to receive insurance repayment (when the incurred loss is relatively minor and is near the threshold of deductible). On the other hand, adverse selection refers to a situation where an insurer cannot distinguish between stakeholders having lower and... 

To alleviate the effects due to moral hazard and adverse selection, introducing pro rata share of the risks and differentiating the rates according to physical parameters related to seismic hazard and vulnerability of the covered properties (e.g., geographical region, structural type, built year, and number of stories) are useful (see Table 1). Other proactive ways to avoid adverse selection and encourage physical DRR measures are to implement an effective incentive scheme in determining insurance premium rates (e.g., Japanese insurance system). 

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