Risky Finance Part 4 Adverse Selection - YouTube

Let's continue talking about insurance.

And we're going to talk about two problems

that come up in insurance markets.

And the first one is what we call "adverse selection."

So, in our previous example, I had this little village,

and everyone in the village had the same risk of fire.

But in the real world, of course,

people have different levels of riskiness.

Some people might have brick homes

that are not very fire prone.

And other little piggies have built houses made of straw

and they're very fire prone.

Some little piggies take really good care of things.

And other piggies, you know, smoke cigarettes

and fall asleep in bed and start fires

and all that kind of stuff.

So, in the real world, different people

have different risk levels.

So, let's think about this insurance

that has a $1,000 premium,

but there's actually two different types of pigs

out there.

Half the piggies have a $2,000 expected loss,

either because they have a high probability of a fire.

Or, if they have a fire,

there is a very high loss associated with it.

And then half the piggies have a $500 expected loss.

So, notice that this still comes out to average out

to be a thousand bucks.

Excuse me.

I got to change this to 1,500 so it will all come out to be--

It still averages out to be a thousand dollars.

Now, what's going to happen is that these low-risk piggies

are going to look at the $1,000 premium

compared to their expected loss, and that insurance policy is not

going to look very appealing to them.

And, in fact, they may not buy that insurance policy,

or at least not all of them will.

But for these other piggies, the high-risk piggies,

not only does this insurance protect them

against the uncertainty of life; they actually make money,

on average, because their expected losses

are 1,500 and they're only paying $1,000

to escape $1,500 worth of expected loss.

So, "adverse selection" refers to a situation where

the high-risk people are more likely to demand insurance.

Now, if the insurance company can figure out

who the high-risk people are and it's allowed

to charge the high-risk people a higher price,

this won't necessarily be a problem.

It will charge the high-risk piggies

a $1500 insurance premium

and charge the low-risk piggies a $500 insurance premium,

and everything will work just fine.

But if they can't tell who the high-risk

versus low-risk people are, or if they are not allowed

to charge different prices based on people's risk levels,

then what's going to happen here is low-risk people

may not want insurance,

because, for the low-risk people,

the insurance is a really bad deal.

Then, if the low-risk people don't buy the insurance,

the average-risk level of the people who actually

show up to buy insurance ends up being higher,

and that means that to just break even,

the insurance company is going to have to charge

a higher premium.

That could possibly even trigger

a slightly less low risk,

sort of the second-lowest risk group of people

to drop out of the market.

And then you get into what's called a "death spiral"

where the insurance company raises rates

to compensate for the fact that its pool of applicants

has become riskier.

That discourages a few more low-risk applicants,

and so on and so forth,

and eventually you just have very, very expensive insurance

that only the people

who are the very highest-risk individuals want to buy.

So, that's one potential problem.

"Adverse selection" refers to, again,

the idea that some people are inherently more risky

than others, and the people who are more risky than others

will have an above-average demand for insurance.