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Adverse Selection Example

Describe either an adverse selection or moral hazard problem a company is facing. MAKE NOTE (describe) the qualities that make it either adverse selection or moral hazard. What is the source of the asymmetric information? Who is the less-informed party? Are there any wealth-creating transactions not consummated as a result of the asymmetric information? If so, could you consummate them? What advice/recommendations would you give the company?

This is an example:

Auto Insurance companies constantly face adverse selection. Companies such as State Farm, Progressive and Geico write policies for young teenage drivers as they enter the licensing stages of their lives. These young, inexperienced eager teenagers pose a huge liability threat to insurance companies daily.

These insurance companies face adverse selection due to asymmetric information. The seller, in this case the insurance company has limited information about the driver. Aside from the age, the insurance company has minimal information about the driver.

As the less-informed party, the insurance companies try to gather data via questionnaires and often student academic performance. All these questions help paint a picture which places the future driver into a "risk" category that is then used to establish an insurance rate.

There are there non-consummated wealth-creating transactions as a result of the asymmetric information. Often insurance companies must charge extremely high premiums in order to balance the risk, forcing some parents to wait until their teenager is older and therefore a lower risk. Personally, we have had our children wait until seventeen to get their licenses. This was inconvenience for us but revenue loss for insurers.

I would offer a program that reduces rates monthly to encourage students to be careful drivers. This affords the parents the knowledge that the quoted rate is subject to a monthly decrease as long as their child does not file a claim. This would be done for the first two years from issue of driver's license or until a lower risk age group is achieved.

I understand the risk must come with a reward, but insurance companies know it is illegal to drive without it. They use this leverage to profit and offer minimal incentives even if you are a good driver. As a driver for over 25 years I have never received a dime back for being a good driver which clearly indicates profit trumps customer appreciation. My advice is to better balance risk and reward with actual rewards.

http://www.rmiia.org/auto/teens/Buying_Auto_Insurance.asp

Solution Preview

Credit card companies face adverse selection with current and prospective customers. For this analysis, I will focus on prospective customers with little to no credit history. Companies like American Express, Discover, and major banks offer student credit cards targeted towards current college and graduate student with very little if any credit history. Although these prospective customers could have turn out to be safe and profitable customers, they could just as likely be very risky customers with a high probability of default.

Credit card issuers face adverse selection due to asymmetric information. The issuers have limited information about the students. While normal customers likely have long, extensive credit histories that can be obtained via credit reports, students typically do ...

Solution Summary

Adverse selection due to asymmetric information is explained using the example of credit card companies.

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