- Death spiral redirects here.
At the core of this problem are two things:
- There is information that is only available to Participant A.
- Participant B has an offer that would change if he had access to the missing information.
Adverse selection then happens when Participant A consciously makes use of the offer, causing a disadvantage for Participant B.
Common countermeasures against adverse selection are screening processes to lessen the amount of private information Participant A has.
This is a quite abstract description, but the concept is fairly widespread, as the following examples show:
For example, somebody with a conviction for drunk driving would have a higher incentive to insure his car against damages than a very experienced and cautious driver. Likewise, members of certain risk groups may have a greater desire to get a life insurance. Without access to the critical information, insurance companies would eventually have to charge higher premiums due to the increased overall risk. This in turn would discourage people with smaller risks to join (since they would have to pay a price that is much too high for them).
In both cases, the insurance companies are at a disadvantage because of the information asymmetry. This is why the usual policy is to have a mandatory screening process (in the case of life insurances, a full medical examination) prior to negotiating the premium levels. This way, insurance companies can charge a higher premium for people with higher risks, allowing people with smaller (observed) risks pay a smaller price (thus making the insurance more attractive for them).
In non recourse factoring, the factor buys accounts receivables (in the form of invoices) from a seller and also carries the risk of the debtor being unable to pay. Some companies sell all their accounts receivables to a factoring company, but others only sell some of them. In that case, the seller may use his knowledge about his debtors to shift the risk to the factoring company (selling exactly those cases that are connected to high-risk debtors).
In this case, one possible way for the factoring company to escape the adverse selection is to create a policy for sellers that only want to sell some of their accounts receivables. For example, sellers may only be allowed to sell a certain percentage of their cases - going alphabetically down the list instead of picking specific cases.
- Moral Hazard and Adverse Selection by Robert Schenk