Which of the following descriptions best exemplifies adverse selection?
A) A manager cannot ascertain the contributions of individual team members in team production.
B) A research scientist uses the organization’s resources to conduct personal research.
C) An employee spends time on social networking sites during work hours.
D) An interview candidate lists his qualifications in chronological order.
The Correct Answer for the given question is Option A) A manager cannot ascertain the contributions of individual team members in team production.
The manager cannot ascertain the contributions of individual team members in team production. Each individual’s contribution to a team is subjective and can only be assessed through individual observation. This makes it difficult to quantify overall team performance and, as a result, managers may not be able to give appropriate recognition or rewards to individuals for their contributions. Team performance is measured by the team’s collective outcome (for example, sales, profit etc.).
A manager cannot ascertain the contributions of individual team members in team production if they are not aware of what each team member is doing. This creates an adverse selection problem, because some employees will not volunteer their time or information to the manager. This lack of communication and transparency can lead to mismanaged projects and a decreased quality product.
When it comes to business, you should avoid dealing with people you shouldn’t do business with. There are mainly two kinds of market failure in the insurance industry. Moral hazard is another. When the buyer and seller have asymmetric information, adverse selection can occur; insurance is often less profitable when the buyer knows more about their claim risk than does the seller. It would be ideal to set insurance premiums based on the risk of a randomly selected person in the insured slice of the population (a 55-year-old male smoker, for example).
For practical purposes, this means an estimated average risk for the population. Adverse selection occurs when the insurance is bought by those who know they have a higher risk of claiming than the average, while those who have a lower risk decide it is too expensive. Due to the fact that more people with a higher risk than those with a lower risk have bought the policy, premiums set according to the average risk will not be enough to cover claims when they eventually arise.
A higher premium will not solve this problem; in fact, increasing the premium will make the insurance policy unattractive to those who are less likely to claim. A good way to reduce adverse selection is to make insurance compulsory, so that those for whom insurance priced for average risk is unattractive cannot opt out.
In the insurance industry, adverse selection refers to the increased likelihood that people who choose to buy insurance policies will file claims over the life of the policy that will exceed the total dollar value of the premiums that they pay. In many cases, people who choose to purchase insurance realize that they have higher risks than the general population and will therefore file more claims in the future. When insurance companies use the risk factors of the general population to set premiums, they will lose money if the number of claims exceeds the population average.
It also increases the likelihood that individuals who are less likely to file future claims will opt out of the plan if insurers raise the costs of the policy to cover the increased claims, which increases the number of individuals remaining in the plan who will file claims. An adverse selection environment is characterized by an unraveling or death spiral.