HOW DO FINANCIAL INTERMEDIARIES SOLVE THE PROBLEM OF ADVERSE SELECTION

lOMoARcPSD| 50120533
DANANG UNIVERSITY OF ECONOMICS FACULTY OF E-COMMERCE
-----🙞🙜🕮🙞🙜----- GROUP REPORT
HOW DO FINANCIAL INTERMEDIARIES SOLVE THE
PROBLEM OF ADVERSE SELECTION? Class : 48K22.1 Group : 6 Members : Dang Thi Thu Hien (100%) Nguyen Khoa Thuy Linh (100%) Luong Thi Thanh Vy (100%) Le Thi Kim Oanh (100%)
Course : Financial Markets and Institutions Lecturer : Phan Dang My Phuong
Da Nang, April 16 2024 lOMoARcPSD| 50120533 REFERENCE
[1] (Adverse Selection: Definition, How It Works, and The Lemons Problem, 2023)
[2] (Financial intermediary, 2024)
[3] (How Adverse Selection Is Used to Determine Insurance Coverage, 2022) [4] (Adverse selection, 2024)
[5] (Insurance Coverage, 2024)
[6] (Insurance premium: What is it and how does it work?, 2022)
[7] (Adverse Selection Example, 2024)
[8] (Adverse Selection: Understanding Its Impact on Financial Markets, 2023)
[9] (Financial Intermediaries: Definition, Importance & Function, 2024)
[10] (Money, Banking and The Financial System, 2016) 2 lOMoARcPSD| 50120533
TABLE OF CONTENT I. Stating a problem ............. Error! Bookmark not defined.
Adverse Selection in Health Insurance: ....................................................................... 3
II. Overview of adverse selection .................................................................................... 5
1. Definition ................................................................................................................. 5
2. Adverse selection in financial markets .................................................................... 5
III. Understanding Adverse Selection ............................................................................. 6
1. Causes of adverse selection ..................................................................................... 6
2. Consequences of adverse selection for financial intermediaries ............................. 6
3. Importance of addressing adverse selection in financial markets ........................... 7
III. Role of Financial Intermediaries ............................................................................... 8
1. Definition of financial intermediaries ...................................................................... 8
2. Functions of financial intermediaries ...................................................................... 8
3. How financial intermediaries mitigate adverse selection ........................................ 9
V. Solving the problem ................................................................................................. 10 I. Stating a problem
Adverse Selection in Health Insurance:
Before diving into the scenario and problems, there are 2 definitions that we need to know:
- Insurance coverage is the amount of risk, liability, or potential loss that is
protected by insurance. It helps individuals recover from financial losses as a
result of incidents, such as unexpected health issues [5].
- An insurance premium is the amount the policyholder agrees to pay in
exchange for coverage. It guarantees financial compensation for the damages or
losses they incur, as long as timely payments are made. Depending on the type
of policy, the insurance company may require premiums to be paid monthly, semi-annually, or yearly [6].
The Scenario: The health insurance market is susceptible to adverse selection.
Healthy individuals might be less likely to purchase health insurance because they
perceive themselves as low-risk and unlikely to need it. Conversely, unhealthy
individuals are more likely to seek health insurance due to their higher risk of needing medical care. 3 lOMoAR cPSD| 50120533
From sellers' perspective: Problem:
Healthy young people, in their invincible youth phase, might see health insurance as
unnecessary. They may choose to forgo insurance or gamble on staying healthy. This
further shrinks the pool of low-risk individuals, leaving insurance companies with a
higher proportion of high-risk customers. This increases their overall claims costs,
necessitating even higher premiums in the future.
The problem is that insurance companies might not have enough information about
their about-to-be customers' health status, and they want to insure healthier people
since they want to minimize their risk. Consequence:
- Higher Premiums: Insurance companies need to cover the higher costs
associated with a pool of sicker individuals, leading to increased premiums for everyone.
- Reduced Access to Care: High premiums may discourage some people,
especially those with lower incomes, from obtaining health insurance
altogether. This can lead to them delaying or forgoing necessary medical care.
- Market Instability: A shrinking pool of healthy individuals can destabilize the
entire health insurance market, making it difficult for insurers to operate profitably.
From buyers' perspective: Problem:
- High insurance prices: make buying insurance unattractive for healthy people,
who feel they are paying for someone else's medical expenses
- Limited coverage: some important health care services may not be covered, or
may have higher deductibles and co-pays
- Limited availability: some people cannot afford health insurance - because
insurance companies feel the risk is too high to insure people at high risk of illness.
⇒ In short, problem from buyers' perspective: How can they get a health insurance
package that truly reflects their own needs and risks, while still ensuring equity and
access to necessary medical services Consequence:
- Higher Premiums: Because unhealthy individuals are more likely to buy
insurance, the overall risk pool for insurers becomes skewed. To compensate
for the higher expected payouts, insurance companies raise premiums for everyone. 4 lOMoARcPSD| 50120533
- Limited Coverage: To keep premiums somewhat competitive, insurers might
offer plans with limited coverage ⇒ buyers to pay more out of pocket when they need medical care.
- Reduced Availability: In severe cases of adverse selection, some people might
be entirely priced out of the insurance market. This happens if insurance
companies deem the risk of insuring them to be too high
- Uncertainty and Potential Denials: more scrutiny from insurance companies
when processing claims ⇒ Create uncertainty for policyholders and can lead to lengthy appeals processes
II. Overview of adverse selection 1. Definition
Adverse selection refers to a situation in which one party in a transaction possesses
more information than the other, leading to a knowledge imbalance that can result in
undesirable outcomes. This phenomenon is particularly prevalent in markets
characterized by information asymmetry, where one party has access to information
that the other lacks, giving rise to potential distortions in decision-making and allocation of resources [4].
2. Adverse selection in financial markets
Adverse selection is a sneaky culprit that can distort financial markets. This
phenomenon can occur across various financial sectors, including insurance, lending,
and securities markets, among others [4]. In insurance markets:
Adverse selection is prevalent in insurance markets. Policyholders possess private
information about their risk profiles, such as health conditions or driving habits, which
insurers may not have access to. As a result, individuals with higher-than-average risk
are more likely to seek insurance coverage, leading to a pool of insured individuals
skewed toward higher risk. This can cause insurers to raise premiums for everyone or
limit coverage options to mitigate their exposure to adverse selection. In lending markets:
Adverse selection occurs when borrowers have better information about their
creditworthiness than lenders. Borrowers who anticipate difficulties in repaying loans
may be more inclined to seek financing, while low-risk borrowers may be less active
in the market. As a result, lenders may face a pool of borrowers with a higher
likelihood of default, leading them to increase interest rates or impose stricter lending
terms to compensate for the elevated risk.
In securities markets:
Adverse selection is also a concern in securities markets, particularly with insider
trading. Insiders, such as company executives or large shareholders, possess 5 lOMoARcPSD| 50120533
confidential information about a company's financial performance, growth prospects,
or pending announcements. When insiders trade securities based on this privileged
information, they can take advantage of less-informed investors, leading to adverse
selection. Unsuspecting investors may purchase or sell securities at prices that do not
reflect their true value, resulting in losses when the information is eventually disclosed to the public.
III. Understanding Adverse Selection
1. Causes of adverse selection
Adverse selection in financial markets can be caused by several factors, all of which
contribute to a disparity in information between parties involved in transactions.
Information Asymmetry:
This is perhaps the most fundamental cause of adverse selection. One party
possesses more or better information than the other party, giving them an advantage in
negotiations. Sellers (or borrowers) often have more private information about the
quality or riskiness of what they're selling (financial product, used car, etc.) compared to buyers (or lenders).
Asymmetric Access to Information:
Even when information is publicly available, not all market participants may have
equal access to it. For example, institutional investors or insiders may have access to
privileged information that is not available to retail investors. This information
asymmetry can lead to adverse selection as better-informed investors capitalize on
their knowledge at the expense of less-informed investors.
Lack of Regulation or Transparency:
In some cases, a lack of regulations or transparency can exacerbate adverse
selection. If there are no requirements for disclosing relevant information, it's harder
for buyers to assess risk accurately [7]. Behavioral Factors:
Psychological biases and cognitive limitations can also contribute to adverse
selection. For example, individuals may exhibit overconfidence bias, leading them to
overestimate their own knowledge or abilities relative to others. This overconfidence
can result in adverse selection if individuals make decisions based on incomplete or inaccurate information.
2. Consequences of adverse selection for financial intermediaries Increased Risk: 6 lOMoARcPSD| 50120533
Due to the inability to accurately assess customers' repayment ability, financial
intermediaries may face higher credit risks. This could lead to having to pay higher
costs for capital mobilization or even losing money due to unpaid loans [1]. Decreased Efficiency:
The inability to distinguish between high and low-risk customers can lead to
financial burdens on intermediaries from dealing with unpaid debts and high credit
risks. This could reduce their overall profitability and efficiency. Loss of Reputation:
If financial intermediaries cannot effectively manage the risks associated with
adverse selection, they may lose credibility in the eyes of both customers and
investors, leading to loss of customers and revenue. Imbalanced Portfolio:
Faced with adverse selection, financial intermediaries may need to adjust their
investment strategies to minimize risk. This could lead to an imbalanced investment
portfolio, where intermediaries may have to accept less profitable or riskier
investments than they would prefer. Regulatory Scrutiny:
Persistent adverse selection issues within financial intermediaries can attract
regulatory scrutiny. Regulators may intervene to impose stricter regulations or
oversight to address the risks associated with adverse selection, adding compliance
burdens and potentially limiting the flexibility of intermediaries in their operations.
Loss of Competitive Advantage:
If adverse selection significantly affects the financial intermediary's ability to offer
competitive terms or attract reliable customers, it may lose its competitive advantage
in the market. Competitors who effectively manage adverse selection risks may gain
market share at the expense of the intermediary facing these challenges.
3. Importance of addressing adverse selection in financial markets
Addressing adverse selection in financial markets is crucial to ensure fair and
efficient market operations. Adverse selection refers to the situation where one party in
a transaction has more information than the other, leading to a knowledge imbalance
that can result in negative outcomes. Here are some reasons why addressing adverse selection is important: Market Efficiency:
Adverse selection can lead to market inefficiencies as uninformed parties may be
hesitant to participate, leading to a lack of liquidity and price distortions. By 7 lOMoARcPSD| 50120533
addressing adverse selection, markets can operate more smoothly and allocate resources more efficiently. Investor Confidence:
When investors perceive that adverse selection is prevalent in a market, they may be
less willing to invest due to concerns about being at a disadvantage. Addressing
adverse selection can help build investor confidence and attract more participants to the market. Risk Management:
Adverse selection can increase the risk of transactions as parties may not have a full
understanding of the risks involved. By addressing adverse selection through
transparency and information disclosure, parties can make more informed decisions
and better manage their risks.
Regulatory Compliance:
Regulators often implement measures to address adverse selection, such as requiring
disclosure of material information and enforcing rules to prevent insider trading.
Adhering to these regulations is essential for maintaining the integrity of financial
markets and protecting investors.
Fairness and Integrity:
Addressing adverse selection promotes fairness and integrity in financial markets by
ensuring that all parties have access to relevant information and are not unfairly
disadvantaged in transactions. This helps to maintain trust in the market and prevent fraudulent activities.
III. Role of Financial Intermediaries
1. Definition of financial intermediaries
A financial intermediary is an institution or individual that serves as a "middleman"
among diverse parties in order to facilitate financial transactions. Common types
include commercial banks, investment banks, stockbrokers, insurance and pension
funds, pooled investment funds, leasing companies, and stock exchanges [2].
The financial intermediary thus facilitates the indirect channeling of funds between,
generically, lenders and borrowers.That is, savers (lenders) give funds to an
intermediary institution (such as a bank), and that institution gives those funds to
spenders (borrowers). When the money is lent directly - via the financial markets -
eliminating the financial intermediary, this is known as financial disintermediation [2].
2. Functions of financial intermediaries
Channeling savings towards investment: 8 lOMoARcPSD| 50120533
Financial intermediaries collect savings from individuals and businesses in the form
of deposits, premiums, etc. They then pool these funds and channel them towards
investments like loans, bonds, and stocks. This facilitates capital formation, which is
essential for economic growth. Liquidity Provision:
Intermediaries enhance liquidity by offering savers instruments that can be easily
converted into cash. This liquidity ensures that savers can access their funds when
needed, even if the underlying assets are not readily marketable.
Facilitating exchange of goods and services:
Financial intermediaries, like banks, provide payment systems that enable the
exchange of goods and services. This includes services like debit cards, credit cards,
and online money transfers, making transactions faster, more convenient, and more secure. Risk management:
Financial intermediaries help manage risks for both lenders and borrowers, helps to
reduce the risk of defaults for lenders. Similarly, they offer investment products with
varying risk profiles to suit different investor needs. Information Provision:
Financial intermediaries conduct due diligence and gather information about
potential borrowers, assessing their creditworthiness and investment opportunities.
This information asymmetry reduction benefits both savers and borrowers by
facilitating more informed decision-making. Capital Allocation:
By directing funds to productive investments, financial intermediaries play a critical
role in allocating capital to businesses, governments, and individuals. This allocation
process supports economic development and wealth creation.
3. How financial intermediaries mitigate adverse selection
Financial intermediaries play a crucial role in mitigating adverse selection in
financial markets. Here's the importance of financial intermediaries in mitigating adverse selection:
Regulatory oversight and compliance:
Regulatory authorities impose stringent standards and guidelines on financial
intermediaries to ensure transparency, fairness, and accountability in lending practices.
Regulatory oversight helps mitigate adverse selection by promoting market integrity,
reducing information asymmetries, and safeguarding the interests of all stakeholders [9]. 9 lOMoARcPSD| 50120533
Information gathering and screening:
Financial intermediaries gather and analyze information about potential borrowers,
including their creditworthiness, financial history, and risk profiles. Through
comprehensive screening processes, intermediaries can identify high-quality borrowers
and mitigate the adverse selection problem by offering loans only to those with a lower likelihood of default. Risk pooling:
By pooling funds from multiple savers, financial intermediaries can spread the risk
associated with lending across a diverse portfolio of borrowers. This diversification
reduces the impact of adverse selection on individual lenders, as losses from defaulted
loans are offset by returns from successful ones. Risk-based pricing:
Financial intermediaries employ risk-based pricing strategies to charge higher
interest rates or impose stricter terms on loans to borrowers perceived to be riskier.
This pricing mechanism helps compensate for the increased likelihood of default
among higher-risk borrowers, thereby mitigating adverse selection and maintaining profitability.
Monitoring and enforcement:
Financial intermediaries actively monitor the performance of loans and enforce
contractual obligations to mitigate adverse selection. Through ongoing surveillance
and timely intervention, intermediaries can detect early warning signs of default and
take corrective measures to minimize losses, thereby maintaining the integrity of the lending process.
Collateral and security requirements:
Financial intermediaries often require borrowers to provide collateral or security to
secure loans, reducing the adverse selection problem by aligning the interests of
lenders and borrowers. Collateral serves as a form of risk mitigation, providing lenders
with recourse in the event of default and discouraging opportunistic behavior by borrowers.
V. Solving the problem
Financial institutions, particularly insurance companies, can't completely eliminate
adverse selection, but they can implement strategies to mitigate its impact [3,8]. For sellers: Risk assessment:
- Insurance companies gather as much information as possible about potential
policyholders through applications, medical history checks, and credit reports. 10 lOMoARcPSD| 50120533
This helps them assess the applicant's risk of needing coverage and set appropriate premiums.
- Based on the risk assessment, different pricing structures are offered.
Individuals with a higher likelihood of needing medical care will be offered plans with higher premiums.
Incentives for Good Behavior:
- Insurance companies can incentivize healthy habits to attract and retain healthy
individuals. This could involve discounts for gym memberships, preventive
care checkups, or participation in wellness programs.
- Offering discounts or premium reductions for long-term policyholders
encourages responsible behavior and reduces the chances of them switching to another company. Product Design:
- High-Deductible Plans: These plans offer lower premiums but require the
policyholder to pay a higher deductible before the insurance kicks in. This can
be attractive to healthy individuals who are less likely to incur significant
medical expenses and can afford a higher upfront cost.
- Catastrophic Coverage: Limited plans focusing solely on major medical events
or hospitalization can be offered at lower premiums, catering to healthy
individuals who may not need extensive coverage but want some protection for unforeseen circumstances.
Monitoring and Claims Management:
- Claims Review: Insurance companies have processes to review claims and
identify potential fraud or misuse of coverage. This helps to ensure that the
system isn't abused by those who are less likely to need coverage.
- Renewal Reviews: Periodic reviews of policyholder health status and claims
history allow for adjustments to premiums or coverage options, reflecting changes in risk profiles. For buyers:
- Provide risk assessment tools: Online tools or calculators can help potential
buyers estimate their risk profile and get an idea of potential premiums before applying for a policy.
- Consulting and educating customers: providing information (side-by-side
comparisons of different plans with varying coverage levels or other
information ) to help buyers make informed choices based on their needs and
budget and advice to buyers about the importance of health insurance and the benefits it brings 11 lOMoAR cPSD| 50120533
- Create a healthy competitive environment: promote a healthy competitive
environment in the health insurance industry, thereby increasing the opportunity
for buyers to find insurance products that suit their needs and minimize negative choice. 12