Information Asymmetry In Financial Institutions And Markets

One of the implicit assumptions of the fundamental welfare theorems is that the characteristics of all commodities are observable to all market participants. However this is not reality. The market participants often hold this information asymmetrically.

Information asymmetry deals with the study of decisions in transactions where one party has more and better information than the other party. This creates an imbalance between both sides of a transaction. Such asymmetries often result in inefficient economic outcome. In 2001, the Nobel Prize in Economics was awarded to George Akerlof, Michael Spence, and Joseph E. Stiglitzfor analyzing markets with asymmetric information. In short asymmetric information refers to the case that is part of traders in the market have more information than the other party. For example, the seller knows more about quality of a good than the buyer, chairman of the board know more about the company's profitability or the insurer knows more about his risk than the insurance company. Asymmetric information doesn’t just occur in the physical goods market. One area that is particularly common with asymmetric information is the insurance market. Buyers (people) in insurance market usually have more information than the seller (insurance companies). For example, for car insurance, the person who buys car insurance has more information regarding his/her driving behavior (risk) than insurance company. Or, a person who buys fire insurance for his house has better information than the insurance company regarding his risky behavior, which might cause a fire. The asymmetric information results in adverse selection problem, which is the phenomenon where people on the informed side of the market self-select in a way that is harmful to the uninformed side of the market. For car insurance market, adverse selection occurs because many “risky” drivers buy car insurance, while only few “safe” drivers buy the insurance. This is mainly due to the fact that insurance company cannot differentiate risky and safe individuals and charges the same premium to both. For life insurance, people who are prone to some diseases and have higher risk of death are more likely to buy life insurance. So, high-risk people are more likely to participate in insurance market and this is adverse selection problem in insurance market. By using National Medical Expenditure Survey, Cardon and Hendel (2001) analyze the adverse selection problem and they find that riskier types buy more coverage and on average end up using more care.

The other problem that insurance companies face is moral hazard. This happens when one party in a transaction involves in risky behavior after the transaction has been completed. This is a common problem in insurance because of the way that people view their belongings. For example, when a consumer buys a new electronic device they are very careful with it because if they break it then they will have to buy a replacement. If they insure it, then they will become more careless about looking after it, because they do not entirely bear the cost of a replacement. In insurance, the moral hazard may be defined as the tendency of insurers’ less effort protecting those goods, which are insured against theft or damage. Moral hazard also refers to situations where one side of the market can't observe the actions of the other. For this reason it is sometimes called a hidden action problem. Moral hazard arises when individuals, in possession of private information, take actions, which adversely affect the probability of bad outcomes. Therefore it is likely that, due to moral hazard, a person who buys fire insurance pays less attention to principals that prevents a fire in a house or a business. Both adverse selection and moral hazard problem leads to market failure.

A market failure is any scenario where an individual or firm’s pure self-interest leads to inefficient results. Insurance companies charge insurance premium based on average risk level. However, this premium level will be high for low-risk insurers. Eventually, the low-risk buyers drop out of the market, causing the average risk level to rise, which in turn leads to a further rise in insurance premiums. This leads more people, who were previously insured, to drop out of the market. Preceding this way, the insurance market gets smaller and smaller and stops functioning. Kangooh (1992) shows that when insurance company fails to charge correct premium, this leads to market failure. Furthermore, moral hazard in the insurance market causes financial losses to insurance providers, because insurers are involved in more risky behavior. This induces insurance companies to increase premiums, which again causes market failure eventually. A special case of moral hazard is very common in management of corporations and companies: principal-agent problem. The Principal Agent Problem occurs when one person (the agent) is allowed to make decisions on behalf of another person (the principal). In this situation, there are issues of moral hazard and conflicts of interest.

When shareholders of an insurance company hire a manager (a CEO for example), the interest of shareholders and the CEO may differ, which causes the moral hazard problem. While shareholders want to maximize the company’s profit, the CEO wants to maximize his/her own benefit. In other word, as long as CEO or other managers gets paid a constant salary, they do not work very hard to make company more profitable. Main cause of principal-agent problem is inability to observe or monitor manager’s effort level. One solution to this problem is to tie managers’ salary to profit of the company. Shareholders simply can offer shares of the company in the compensation package of the manager. This way manager’s interest and shareholders interest will be the same: maximizing the value of the firm.

Although moral hazard and adverse selection may lead to market failure, there are possible ways to mitigate the problem. Stiglitz (1975) developed the idea of “screening”, where after screening process the insurance company can distinguish between different classes of risk to policyholders, giving them the opportunity to choose from a list of alternative contracts. So, to avoid adverse selection problem the insurance company, with access to lots of data about the profile of customers, can come up with filters and screening mechanisms that help identify high risk clients and charge them higher premiums and similarly, offer lower premiums or better deals to low risk clients.

To reduce moral hazard problem, insurance companies impose deductibles and co-insurance in the contract. A deductible is the amount you'll pay out-of-pocket each year before your insurance provider begins to cover any costs. While co-insurance is the percentage of costs of a covered by the insurer after deductible is paid. For example, a $500 deductible and 10% co-insurance in car insurance means that in case of a crash, you will pay the initial $500 of expenses and 10% of the remaining cost. This kind of contract will significantly reduce moral hazard problem. Indeed Thönne (2015) finds that participating in the premium refund tariff (with deductible) significantly reduces the probability of visiting a general practitioner by 6 percentage points.