Issues of Adverse and Moral Selection

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• MUKHTAR MUHAMMAD AHMAD

DISTINGUISH BETWEEN ADVERSE AND MORAL SELECTION, AND HOW A FIRM MIGHT OVERCOME EACH PROBLEM

Adverse selection can be said as the process that occurs when seller valued goods more highly than the buyer does, because the seller has the full information and understanding about the good. Due to this information known by the seller, the seller is unwilling to part with the goods for any price lower than the value the seller knowns it has. On the other hand, the buyer who has no any information about how good the product is, is unwilling to pay more than expected of the good, which take into account the possibility of getting a bad piece.

It is the Asymmetry information prior to the transaction that prevent the transaction from happening. If both the seller and the buyer were not sure of the quality, they would be willing to trade based on its actual value.

Moral hazard, is usually seen as services such as insurance and warranties. In this case, when the deal is done, one of the party involved in the deal (in this case, the person purchasing the insurance) may be less careful because he/she has the insurance, thus is not expected to the full cost the losses insured. Example, a person with an insurance against theft may not border about closing all what is necessary when leaving the house, here, it is not the prior information that either party has ,but due to lack of information that the insurance company has in providing and controlling the risk taking behavior that can leads to the market failure. Lets look into adverse selection in details especially in the case of insurance.

Adverse selection; can also be said as the selection originally used in insurance. Its describe a situation where in an individual’s demand for insurance (The propensity to insurance and quantity purchased) is possibly the individual’s risk of loss (higher risk buy more insurance), and the insurer is unable to allow for this correlation in the price of insurance. This may be because of an information known only to the individuals. (Information Asymmetry), or because of regulation or social Norms which prevent the insurer from using certain categories of known information to set price (For example, gender, genetic, test or pre existing medical conditions. The last of which amount to a 100% risk of losses associated with the treatment of the condition).The letter scenario is sometimes referred to as ” regulatory adverse selection”.

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The potential adverse nature of the phenomenon can be described as the link between the smoking status and mortality of those not smoking, on the average, are more likely to live longer, while smokers on average are more likely to die younger. If the insurer did not distinguish the prices for life insurance according to the smoking status, life insurance would be better buy for smokers than does not smoking. In this case, the smokers may be more willingly to buy insurance or may tent to buy larger amount of the insurance than the does not smoking, there by raising the average mortality of the combined policy holder group above that of the general population. From the insurer’s view point, the higher mortality of the group which select to buy insurance is adverse. The insurer raises the prices the insurance accordingly and as a consequences, does not smoking may be less likely to buy insurance (Or may buy smaller amounts) than they would buy at a lower prices reflectively to their lower risk. The reduction in the insurance purchases by does not smoking is also adverse from the insurer’s view point, and may be also from public policy view points.

Furthermore, if there is a range of increasing risk categories in the population, the raise in the insurance prices because of adverse selection may leads to the lowest remaining risk to cancel or not renew their insurance. This promote a further raise in price, and so on. Eventually this ”adverse selection death spiral” might in theory leads to the collapse of the insurance market.

SOLUTION TO ADVERSE SELECTION PROBLEM

Alternative solution to the effects of adverse selection to the insurers (to the extent that law permit) ask a randomely question requesting medical or other reports on individual who apply to buy insurance so that the price quoted can be varied accordingly, and any unreasonable highly or unpredictable risk rejected. This risk selection method is known underwriting in many nations, insurance law incorperate as ”utmost good faith doctorine. Which requires potential customers to answer any underwriting question asked by the insurer fully and honesty; if they fail to do so, the insurance may refused to pay the claim.

While adverse selection in theory seems a clear and inevitable consequences of economic incentives, empirical is mixed. Several studies investigating correlations between risk and insurance purchased has fail to show the predicted possible correlation of life insurance. On the other hand, positive test result in adverse selection have been reported in health, long term care and annuity market. These possible result tent to be based on demonstrating more subtle relationship between risk and purchasing behavior (such as between mortality and whether the customer chooses a life annuity which is fixed or inflation linked), rather than simple correlations of risk and quantity purchased.

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MORAL HAZARD

Moral Hazard is a situation in which a party is more likely risk because the cost that could be result which not be borne by the party taking the risk. In other words, it is a tendency to be more willing to take the risk, knowing that the potential borden of taking such risk will be born in whole or in potentially by others, A moral Hazard may occur where the actions of one party may changes to Sthe detriment of another after the financial transaction has taken place.

Moral Hazard arises because an individual or institution does not take the full consequences and responsibility of its actions, and therefore, has a tendency to act less careful than its otherwise would leaving another party to hold some responsibility for the consequences of those action.

Economists explain Moral hazard as a special case of information asymmetry, a situation in which one party has a wider information than the other in particular moral hazard may occur if the one that is been cheated from the risk has more information about the action and intention than the one paying for the negative consequences of the risk, more broadly, moral hazard occurs when the one with more knowledge about its action or intention has a tendency or incentive to behave inappropriately from the perspective of the one with less information.

Moral Hazard is also arises in a principal Agents problem, where one party, called an agent acts on behave of another individual called principal. Usually have the knowledge about his action than the principal agents does due to the principal. Usually can not completely monitor the agents. The agents may have incentive to act inappropriate way. (From the view point of the principal) if the interest of the agents are the principal are not alligned.

SOLUTION TO MORAL HAZARD

Alternative way a firm can solve a problem of Moral hazard is the major aspect of the insurance deals with the effect of the availability of insurance on the level of care exercised by the insured to reduced the probability of loss. When an insured policy is not available like in the case of theft, an economic agent could devoted time to watch his property. At the extreemed, he could insure that the probability of losses was zero, but the cost of such strategy would likely be prohibitive. For example, the optimal action is to be expand on effect less than that require to reduce. The probability of theft to zero and hence, to bear the some risk. If we assumed the economic agents are risk averse, they would be willing to pay for transferred of risk to another Agents thereby enhancing their welfare. This transferred of risk is obtained through the purchase of an insurance policy.

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In conclusion, Adverse selection is the selection before the deal or transaction is done in which the person with the product or selling, valued and worth the good than the buyer in the sense, the seller has the better understanding and knowledge about the good and buyer who with less information about the good, would just purchase it based on his own assumption of the quality of the goods. and here, to counter such problem, the seller would have to emphasize more of his products and try to study the consumer behavior before getting into any transaction. while Moral hazard on the other hand, is the situation that occurs when the transaction is done that is, when the deal is done. One of the party in the transaction. here, the person taking the risk is more likely to be the one with the full information in the transaction and acted less carefully knowing that he would not bear the full losses alone thereby, affecting the one with less information about the transaction without his consents. To solve such problem, the insurer has to have an agreement on the facts that, the one that acted carelessly would likely be the one to bear more losses. That would make the one with more information to be more serious in the deal and avoiding any lapses that would occur after the deal is done.