Asymmetric Information, Adverse Selection, and Moral Hazard

Introduction

In the contemporary business environment, insurance markets face ongoing challenges related to asymmetric information, adverse selection, and moral hazard. This paper discusses each of these concepts as they apply to the insurance market and examines the market responses that have been developed to address them.

Market Response to Asymmetric Information

Asymmetric information is a situation in which one party to a business transaction has superior or more information than the other parties. In other words, it occurs when sellers have more information than buyers, although the reverse can also happen in some situations (Lillo, 2013). This type of transaction can be harmful because the better-informed party may exploit the other party's lack of knowledge. Asymmetric information is especially problematic in insurance markets, where a borrower often has superior information compared to lenders. For example, in a health insurance market, buyers of health insurance policies typically know more about their own health than insurance providers do, and they may conceal health problems in order to obtain lower premiums. However, if an insurance provider can access a potential customer's health history and discovers that it has deteriorated, the provider will charge a higher premium. Because customers are often able to conceal their health information, they may avoid paying higher premiums. This is a classic example of asymmetric information.

Asymmetric information can cause market failure because one party lacks adequate information to engage in a profitable transaction. It is particularly harmful when sellers possess more information than buyers, or when one party exploits the other's ignorance. Moral hazard is another problem stemming from asymmetric information; for instance, people who hold fire insurance may alter their behavior after obtaining the policy and become more likely to commit arson in order to claim the insurance benefits.

Signaling is one strategy for addressing asymmetric information, whereby informed sellers communicate the quality of their products and services to buyers. This is especially important for profit-driven businesses, which should provide adequate and accurate information to consumers in order to gain competitive market advantages. Firms that share sufficient information with consumers are likely to attract more customers than those that do not.

Advances in information technology have reduced the problems associated with asymmetric information, as more people can now access a wide range of information via the internet. Technology can also help insurance providers avoid high-risk buyers, since it is now possible to access a potential client's health history online through third-party services. Another market response to asymmetric information is to increase premiums. For example, when an individual seeks life insurance and the provider cannot obtain adequate information about the client's lifespan or health, raising the premium compensates for the information gap and offsets the associated risk and uncertainty.

An analysis of Coca-Cola's business conduct reveals that the company has engaged in asymmetric information practices toward its customers. In the United States, sugar-sweetened soft drinks are among the largest contributors to obesity. Yet many consumers who drink products such as Coca-Cola are unaware that a 20-ounce bottle contains over 15 teaspoons of sugar and 240 calories (Illinois Public Health, 2014, p. 1).

Furthermore, "there is strong scientific evidence that Sugar-Sweetened Beverage (SSB) consumption is directly linked to obesity and other related, and expensive, chronic illnesses such as type 2 diabetes and cardiovascular disease" (Illinois Public Health, 2014, p. 1). The company is able to obscure information about the sugary content of its products through aggressive marketing campaigns and health-oriented labeling. This is a clear example of information asymmetry. Public health education is one effective strategy for overcoming this type of information imbalance.

Adverse selection refers to a situation in which buyers have better and more complete information than sellers. For example, in the insurance market, people in poor health are more likely to purchase life insurance than healthy individuals. Adverse selection is problematic for insurance providers because buyers consistently know more about their own health than sellers do (Tomlinson, n.d.). If only high-risk customers demand life insurance and insurance companies charge an average premium, the companies will incur losses. Similarly, people living in high-crime areas are more likely to insure their vehicles against theft than those living in low-crime areas. If an insurance company charges an average rate in such cases, it will also make a loss. Thus, adverse selection arises when it is difficult to identify the right customers due to information asymmetry. One consequence of adverse selection is that a large proportion of life insurance purchasers will be high-risk individuals, which in turn forces low-risk customers to forgo coverage because they find the premiums too expensive. Additionally, people who smoke or do not exercise are more likely to seek health insurance (Smith, 2013).

Market Response to Adverse Selection

The best strategy insurance companies can employ to avoid adverse selection is to require a physical health examination for applicants seeking health or life insurance. Insurance companies should also investigate the health history of prospective customers before making coverage decisions. A medical examination is a form of screening that helps providers collect adequate information about a prospective customer's health, thereby reducing the problem of asymmetric information.

Equalizing information and restricting opportunistic behavior are additional market responses to asymmetric information. To restrict opportunistic behavior, markets can develop policies that leave informed parties with no option but to disclose information, thus preventing adverse selection. For example, governments can enact laws mandating that everyone purchase health insurance. Many U.S. states already require all vehicle owners to carry auto insurance, which helps reduce reckless driving. Similarly, some firms require all employees to enroll in health insurance plans. When both healthy and unhealthy individuals are covered, insurance providers can more effectively manage the problems associated with adverse selection.

Markets can also use screening methods to help uninformed parties assess the authenticity of information. One example is a test drive, which allows an insurer to evaluate information provided by someone seeking motor accident insurance. Many banks in the United States also use screening to evaluate the financial history of prospective borrowers. Insurance companies can reduce adverse selection by examining potential customers' drinking and smoking habits before offering health insurance coverage.

A moral hazard is a circumstance in which individuals alter their behavior after obtaining an insurance policy and begin to engage in riskier conduct. For example, a person who insures their home against fire may become less careful after obtaining the policy. Moral hazard is a significant problem in insurance markets because some policyholders may behave recklessly once their coverage is finalized. For instance, a bicycle without insurance may have a 10% chance of being stolen; once insured, that chance may rise to 30% due to the owner's reduced vigilance in protecting the bike.

The best strategy for overcoming moral hazard is to require the customer to make a down payment or co-payment. In addition, insurance companies can make the claims process more demanding, which encourages customers to remain careful even after a policy is in place.

In the contemporary business environment, a market signal is a mechanism through which sellers provide sufficient information about their products to gain competitive advantages. A lack of information may cause some buyers to underestimate product quality. Under conditions of adverse selection, sellers can educate consumers by signaling the quality of their products through informative advertising.

Conclusion

Smith, P. (2013). Econ in HD: Moral hazard and adverse selection [Video file]. Retrieved April 27, 2016, from https://www.youtube.com/watch?v=XH70zIJP5cM

Tomlinson, S. (n.d.). Market failures uncertainty: Understanding moral hazards in markets. Cengage.