Adverse selection

When buyers can't see quality, they pay only for average quality. Sellers of good units then withdraw, leaving "an adverse selection of low-quality goods, the lemons" (as summarized in the Nobel committee's 2001 scientific background).

One blended price or bid pulls in the worst slice of your applicants, vendors and leads.

Where vocabulary such as moral hazard begins. Arrow warns that rivals offering "lower premiums to preferred risks" leave a plan that doesn't discriminate "with only an adverse selection of them."

Cream-skimming got its name in 1963. If you don't sort your customers, a competitor will do it for you.

Insurers screen with a menu: full cover at a high price that attracts high risks, and a cheaper policy with a deductible that attracts low risks. A single pooled price can't survive, because a rival can "cream-skim" the low risks.

Tiers and commitments sort your customers. Put out one flat offer and you're inviting competitors to take your best ones.

Raising the interest rate attracts riskier borrowers and changes how borrowers behave, so "it may be optimal for banks to ration the volume of loans instead of raising the lending rate" (as summarized in the Nobel committee's 2001 scientific background).

The terms you set decide who applies. Raise the price to cover the risk, and the safest borrowers are the first to walk away.

When Harvard switched to contributing the same amount to every employee health plan, competition "reduced Harvard's premiums by 5 to 8 percent," but adverse selection caused "a welfare loss of 2 to 4 percent of baseline spending." Einav and Finkelstein call it "an empirical case study of a death spiral." A companion chapter (Cutler and Zeckhauser) reports the generous plan disappeared "within three years."

This death spiral really happened. Flat pricing plus free choice sorts your costliest customers right into your richest offer.

Adverse selection "exists in some insurance markets but not in others." Some markets show advantageous selection, where the most eager buyers are the most careful and cheapest to serve.

This is the counterpoint. Adverse selection doesn't show up everywhere, and sometimes your most eager buyers are your best, so measure it in your own book. It's also the clearest one-chart picture of the mechanism.

From randomized mail solicitations, "respondents to solicitations are substantially worse credit risks than nonrespondents," and people who accept inferior offers are "significantly more likely to default," even after controlling for everything the issuer knew.

A high response rate doesn't mean quality. The worse your offer, the worse the people who answer it.

People who respond to "inferior solicitation offers have poorer credit quality attributes" and "are significantly more likely to default ex post."

A peer-reviewed study found the same thing. How you design the offer decides which customer you get.

58,000 randomized offers from a South African lender separated who signs up from how they behave afterwards. The study found "strong evidence of moral hazard and weaker evidence of hidden information" and that "perhaps 13% to 21% of default is due to moral hazard."

Your terms change how customers behave after the sale, not only who buys. So don't blame everything on selection.

At a subprime auto lender, demand is "highly sensitive to down-payment requirements," "default rates rise significantly with loan size," and "higher-risk borrowers demand larger loans."

This one paper gives you two signals. The size of the ask tells you something, and a down payment works as a screen.

Applicants insurers reject hold enough private information "to explain a complete absence of trade" in long-term care, disability and life insurance.

Some segments can't be served profitably at any price, so turning them away makes sense. A "no" to those applicants isn't a lost sale.

Harvard's switch to contributing the same amount to every health plan "led to the disappearance of the most generous policy within three years." The arrangement "began with about half of the employees in 1995; the other half joined in 1996." The employees who left the PPO were "healthier and younger than those who stayed." The required contribution for the PPO, "which was about $500 in 1994, rose to more than $2,000 in 1996." Enrollment "was stable at about 20% of Harvard employees," fell "from 20% to 15%" in 1995, then "plummeted to about 9% of total employees." To break even, "the PPO premium and charges would have to increase dramatically." "The adverse selection death spiral twisted swiftly." The Group Insurance Commission of Massachusetts "contained adverse selection by subsidizing premiums proportionally."

The death spiral told year by year, with the price and the enrollment. One price rule for everyone, and the healthiest customers left first.