Question

Students often have trouble distinguishing between adverse selection and moral hazard. Both concepts are rooted in asymmetric information among different parties in a transaction or contract. Both contribute to risk and these risks arise from a specific source – asymmetric information

In this week’s forum, I would like you to engage with each other to clarify your understanding of these concepts.

Discuss the prevalence of asymmetric information in insurance contracts, in lending, in investment…

Discuss adverse selection. Any examples.

Discuss moral hazard. Any examples?

How are the two different?

When you apply at a financial institution for a loan, you asked to fill out extensive loan applications, provide detailed financial information, provide loan collateral, etc. In addition, you may find that the money is dispensed to you as you meet certain performance criteria (example, as in a construction loan). Discuss how the loan approval and distribution process reduce risks to the financial institution associated with both adverse selection and moral hazard.

Answer 1

Asymmetric information means when one of the parties involved in the transaction has incomplete information. This could be in case of healthcare, insurance, etc, and could lead to market failure. There are two types of asymmetric information: One that occurs before a transaction and one that occurs after the transaction. In insurance contracts, the company would have less information about the health of the individual, his habits, lifestyle etc and this could increase the probability of the claiming of insurance. Eg: If a person smokes and this fact is not disclosed to the company, then there would be health issues arising with a higher probability which the company would not have analyzed.

Lending and investments also have asymmetric information. These could be when the investor has less information about the nature of investments or the lenders have less information about the way their loans would be utilized. This could mean that the borrower could be indulging in risky investments without the knowledge of the investor or the lender.

Adverse selection occurs before a transaction takes place. This could be concealing of facts by the seller who is selling a good and service and could lead to market failure. Eg: In the case of the car market, there are both good and bad cars and the seller has the information. SO the seller might not disclose the poor quality of his car and try to sell it with the better ones.

Moral hazard is the type of asymmetric infiormation which occurs after the transaction has taken place. This could be due to the fact that the party becomes careless after the transaction. Eg: If Jack has brought a life insurance and then enrolls in dangerous sports, then this would be moral hazard.

Another example could be that a person stops locking his car after the car insurance is done against theft. This information would not be available to the insurance party and hence this could lead to market failure.

These two are different as moral hazard occurs after the transaction and adverse selection occurs before the transaction.

The loan approval and distribution process has improved over the years. Due to increasing bad loans, the banks are now closely scrutinizing the process of loan approval. This is done by screening and monitoring of the potential borrowers by analyzing their credit score, income, previous loans, etc. This has led to increased chances of lending to those who have a higher probability of returnibng the money. So this would inturn reduce the risk of adverse selection.

Also once the loan is approved, the bank can have regular checks on the borrower like if the loan is taken for construction purposes, the bank can give partial loan till a certain percentage of construction is completed. This would ensure that the squandering of money is not done and the purpose for which it is approved is being fulfilled. The bank can have regular visits to the site or the designated area and this would ensure that the borrower is using the money for veritable purposes.There could also be deductible and coinsurance in case of health insurance such that the individual is not resorting to moral hazard. This would help reduce the risk of moral hazard.

(You can comment for doubts)