Adverse Selection vs Moral Hazard: Difference and Comparison

Key Takeaways

1. Adverse selection: Information advantage used to select undesirable risks before a transaction.
2. Moral hazard: Behavior change after a transaction due to protected consequences.
3. Both highlight challenges of information asymmetry in economic interactions.

What is Adverse Selection?

Adverse selection is an economic term that describes a situation where one party in a transaction has more information or a better understanding of the risks involved than the other party. This knowledge asymmetry can lead to undesirable outcomes or “adverse selection” in the market.

In insurance or financial markets, adverse selection occurs when individuals or firms with a higher risk profile are more likely to seek out and purchase insurance or financial products. This happens because they have private information about their risk level that the insurance provider or financial institution cannot access.

What is Moral Hazard?

Moral hazard refers to the concept in economics and insurance where one party, protected from the consequences of their actions, may behave differently or take on higher risks than they would if they were fully exposed to the potential negative outcomes.

It arises due to insurance, guarantees, bailouts, or other forms of protection that reduce the individual’s liability for their actions.

In insurance, moral hazard occurs when individuals or organizations alter their behavior or increase their risk-taking once they have insurance coverage. Knowing that they will be compensated or protected from the financial consequences of their actions, they may engage in riskier behavior that they would otherwise avoid.

Difference Between Adverse Selection and Moral Hazard

1. Adverse selection arises due to asymmetric information before a transaction occurs. One party has superior information about its risk level or quality compared to the other party. In contrast, moral hazard involves asymmetric information arising after a transaction. One party alters their behavior or takes on higher risks because they are protected from the consequences.
2. Adverse selection occurs before a transaction and influences the decision to engage. It affects the composition of the parties involved. On the other hand, moral hazard occurs after a transaction, impacting the behavior of the party protected from the consequences.
3. Adverse selection concerns higher-risk individuals or entities more likely to participate in a transaction or market. It leads to a skew in the risk composition. In contrast, moral hazard focuses on changes in behavior or increased risk-taking by individuals or entities protected from the consequences, regardless of their initial risk profile.
4. Adverse selection can be mitigated by employing risk assessment, underwriting, and pricing mechanisms to differentiate and account for varying risk levels. Moral hazard is addressed through risk management strategies, monitoring, and introducing incentives or penalties to discourage excessive risk-taking or irresponsible behavior.
5. Adverse selection is addressed through information gathering and risk assessment before a transaction. Measures to mitigate moral hazard are implemented after a transaction has taken place to manage the behavior of the party to protect from the consequences.

Comparison Between Adverse Selection and Moral Hazard

Parameters of Comparison	Adverse Selection	Moral Hazard
Information Timing	It occurs before a transaction takes place.	Arises after a transaction has occurred.
Impact on Transaction	Affects the composition of the parties involved in the transaction.	Alters the behavior and actions of the party protected from consequences.
Risk Profile	Focuses on the presence of higher-risk individuals or entities in a transaction or market.	Involves changes in behavior or increased risk-taking by individuals or entities, regardless of initial risk profile.
Mitigation Approach	Employing risk assessment, underwriting, and pricing mechanisms to account for varying risk levels.	Implementing risk management strategies, monitoring, and incentives or penalties to discourage excessive risk-taking or irresponsible behavior.
Timing of Intervention	Mitigation measures is applied before the transaction takes place to address information asymmetry.	Measures are implemented after the transaction to manage behavior and mitigate risks.

References

1. https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6261.1986.tb05051.x
2. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=515903