Adverse Selection in Risk Markets - Essay Example

Introduction: Market risk is the factor that is associated with different factors like the portfolio, investment, interest rates etc when they are decreased enormously. The different types of risks are related to the stock, interest rates, commodity exchange, foreign exchange pricing etc. Market risk is a common term related to the assets and liabilities, which depends on the economical factors of the market which can cause increase or decrease in the value. “Statisticians and economists associate risk with variability. From this we define risk to mean the variation of actual outcomes from expected outcomes e.g. in an investment decision-Expected outcome = profit; actual outcome=loss hence risk.” (Insurance and risk management IIA course notes, n.d., p.1). “Risk comprises two components: uncertainty, and exposure. If either is not present, there is no risk.” (Market risk, 1996). Adverse selection is the term used in insurance and economics; it is the negative selection process which has unfair results in the market process due to misinterpretation in the transactions by the sellers and the buyers. “Adverse selection is the proclivity of those with higher risk to purchase insurance in greater amounts than those with lower risk. Much of insurance law and practice is designed to control adverse selection.” (Chandler, 2009,para.1). As far as the insurance field is concerned, the main dealing is with the sales offers and the benefits, with the main aim of increase in price and quantity. The insurance companies are much useful for the good coverage in accident claims. “The concept of an economic equilibrium is fundamentally very complex and subtle. The goal is to derive the outcome when the agents described in a model complete their process of maximizing behaviour.” (Equilibrium, n.d., para.1). Rothschild and Stiglizt (1976) introduced the model of competitive insurance. According to them, the equilibrium is extinct under the asymmetric information and the pooling contracts and the firm has nullified profit and is extinct. The equilibrium is the condition where supply and demand for the product get equalized with the price, surplus and the shortage as a constant. “Another way of dealing with risk is by pooling it using insurance. The idea is simple.” (Schenk, n.d., para.1). According to them, the selection is based not on the honesty traits but on the risk factor in the market. Audit is conducted often; the high risk policies are audited more than the low risk policies. If any threat is caused to the insurance company in terms of bankruptcy or shut down of the operations, it has the effect on the low risk policy firms and their expected utility and the fair insurance. The assumption is based on the risk analysis based on private information. “Since the seminal work by Rothschild and Stiglitz (1976), it has become clear that competitive insurance markets under asymmetric information display features not known from the conventional competitive analysis.” (Wambach, 2000, para.2). One of the alternative concepts used is to identify and analyze the asymmetric information on the risk type which creates the opportunity for the policy holders. If the policy holders are classified on the basis of risk and honesty, 4 types of policy holders can be identified; they are the ones who take out policy for investment; second consists the ones who see whether they are at profit or at loss; the third is the category for honesty based policy owners and the fourth being claimants for insurance. "Adverse Selection" happens when unusually high-cost people select an insurance plan. Informally, people often use the term adverse selection when people with expected costs that are higher than a population average sign up for a policy.” (Adverse selection and cream skimming, 2006, para.1). The insurance policies are of different kinds; if the availability of each policy is at the same rate, the policy suppliers have to face the risk and it adds on to the non-profit rearing organizations. The insurers are keen in cautious adoption of adverse selection by measuring the risk process and charging higher rates for higher risk associated. The motorists are charged at high premium that are proven by statistics. The high rate is due to high risk associated with the complicated accidents. The motor accidents are always complicated resulting in major loss. The tendency of those with the high risk is much related to the insurance. In motor accidents, the more challenge is for the life of the people and the accidents causing a bitter condition to the vehicle. As far as motorists are concerned, the premium can match with risk because the risk in the motor accident is considered to be too high compared to healthcare or the housing. The major charges are on repairing of the vehicle and a large sum is involved in this process, so when the motorists meet with accidents the risk associated and the money required is too high. This is also at an ease for the motorists to have the best of the insurance return. Insurance is the payments as compensation for the loss occurred accidentally or unexpectedly. “Insurance is designed to protect the financial well-being of an individual, company or other entity in the case of unexpected loss.” (Insurance: Definition, n.d., para.1). It is designed by certain law; it is the payment made by the person, known as premium for the future compensation or the return. Risk is an uncertain factor; it can happen due to different uncertainties and catastrophe incidents. Risk is the factor free from the boundaries. Risk is the only factor that cannot be analyzed accurately; only a forecast can be done. Assessment cannot be done by the motorist in terms of the vehicle type or the driver as there are risks involved by the other motor vehicles colliding with the vehicle, the catastrophic failure related to the vehicle. Nowadays people think that the insurers respond to the adverse selection in terms of hiring the drivers on age basis, contract basis and group contracting basis. The risk pooling of the insurance sector is the combination of the small insurance sector to form better coverage of insurance against catastrophe like the flood, earth quake etc. In this pool the insurance company forms a group to form different kinds of requirement in the insurance sector. The risk pooling has certain concepts of the supply chain management; the supply chain consists of the analysis of demand and supply of the products. It also helps in the availability of the products in the right place and in the right time provided. “Insurance pooling is a practice wherein a group of small firms join together to secure better insurance rates and coverage plans by virtue of their increased buying power.” (Insurance pooling, 2009, para.1). The insurance company differentiates risk factor from person to person. There are different limitations for the insurance, the limited capacity of the insurers doesn’t cover the clients in an adequate manner, the premiums depend on certain external factors that have no direct bearing. The distinguishing factor from the individuals is contrary to the social and economic factors due to the range of the policies. The premium amount varies in each of the sector. The insurance sector plays major role in the annuities, motor insurance and the long term insurance. “Humans have always sought to achieve security and reduce uncertainty. Risk lies at all levels of human and business activity.” (Insurance and risk management IIA course notes, n.d., p.1) Conclusion: Insurance policy is the big surety in terms of payments, cash and other compensation for the potential loss; the growth and the size of the insurance firms shows the interest of the people to be a part of insurance. The selection process of the insurance also gives a better idea of the choice of the policy to be made by the people. The benefits of different premium and schemes also contribute an indirect support to the individuals. The adverse selection also finds a boon to the motorists who are eligible for a better payment. Reference List Adverse selection and cream skimming. (2006). Health Insurance.info: the Consumer’s Health Insurance Authority. Retrieved January 5, 2010, from http://www.healthinsurance.info/HISEL.HTM Chandler, S.J. (2009). Adverse selection. Wolfram Demontrations Project. Retrieved January 5, 2010, from http://demonstrations.wolfram.com/AdverseSelection/ Equilibrium. (n.d.). Econ Model. Retrieved January 5, 2010, from http://www.econmodel.com/classic/terms/equilibrium.htm Insurance and risk management IIA course notes: The concept of risk. (n.d.). University of the Witwatersrand School of Economic and Business Sciences. Retrieved January 5, 2010, from http://uamp.wits.ac.za/sebs/downloads/2006/the_concept_of_risk.doc Insurance: Definition. (n.d.). Investor Words.com. Retrieved January 5, 2010, from http://www.investorwords.com/2510/insurance.html Insurance pooling. (2009). Answers.com. Retrieved January 5, 2010, from http://www.answers.com/topic/insurance-pooling Market risk. (1996). Risk Glossary.com. Retrieved January 5, 2010, from http://www.riskglossary.com/link/market_risk.htm Schenk, R. (n.d.). Insurance. Retrieved January 5, 2010, from http://ingrimayne.com/econ/RiskExclusion/Risk.html Wambach, A. (2000). Introducing heterogeneity in the Rothschild –Stiglitz model. Journal of Risk and Insurance. All Business: A D&B Company. Retrieved January 5, 2010, from http://www.allbusiness.com/management/benchmarking-strategic-planning/717658-1.html Read More