How do companies mitigate adverse selection and moral hazard from asymmetric information? How do hidden characteristics or profiles exacerbate adverse selection? How do hidden actions and material changes in behavior exacerbate moral hazard? The answers to these strategic questions are critical to the effective formulation and execution of optimal adverse selection and moral hazard mitigation strategies that equate marginal costs with marginal benefits. In addition, the optimal mitigation strategy minimizes the known likelihood and incidence of decision failures with associated adverse effects and maximizes the profit-producing capacity of the business.

In this review, we examine some relevant and existing academic literature on effective adverse selection and optimal moral hazard mitigation strategies. Each mitigation strategy has costs and benefits. Therefore, the objective function is to maximize the net benefit of mitigation strategies. In practice, the optimal risk mitigation strategy equates marginal costs with marginal benefits, minimizing the incidence of adverse effects from poor decisions and maximizing the profit-producing capacity of the company.

Adverse selection and moral hazard are terms used in risk management, management economics, and political science to characterize situations where one party to a market transaction is at a disadvantage due to information. asymmetric. In market transactions, adverse selection occurs when there is a lack of symmetric information prior to agreements between sellers and buyers, while moral hazard occurs when there is asymmetric information between the two parties and material changes in the behavior of one of the parties. parties after the agreements have been concluded.

For example, adverse selection arises in any situation in which one of the parties to a contract or negotiation possesses material information relevant to the contract or negotiation that the other party lacks; This asymmetric material information leads the party that lacks relevant and material information to make decisions that cause adverse effects. Therefore, adverse selection occurs when one of the parties makes decisions without all the relevant material information, which changes the allocation of risks between the parties to the transactions.

When one party has access to better information or relevant material than the other during a transaction, it is said to have asymmetric information. Therefore, when one of the parties has asymmetric information, it can make an adverse selection. Adverse selection arises when the actual risk is substantially greater than the known risk at the time the agreement is reached. One party is adversely affected by accepting terms or receiving prices that do not accurately reflect actual risk exposure. The consequences of asymmetric information can be exacerbated by the bounded rationality and cognitive biases that accompany the more competitive use of information. On the contrary, moral hazard occurs when a party conceals or misrepresents relevant material information and changes behavior after the agreement is concluded and is protected from the consequences of risks emanating from a material change in behavior.

The economic and political sciences suggest that decision makers must not only know, but understand and anticipate the consequences of asymmetric information to mitigate the risks of adverse effects associated with adverse selection and moral hazard. There are classic examples from academia and the insurance industry.

Unscreened academic programs attract a disproportionate number of students whose prior academic background and profile make them at increased risk of academic success, retention, graduation, and placement. In fact, this is a classic case of adverse effects derived from adverse selection and moral hazard.

For example, the unscreened admissions process combines recruitment and selection, resulting in adverse selection. And once admitted, refusal to attend classes, refusal to complete assignments, refusal to take notes in classes, critical listening, disruptive and inattentive behavior in classes are instances of post-enrollment moral hazard that they make unscreened students at higher risk of retention. graduation and placement. Note that it is not the behavior change per se that causes moral hazard in this case. It is the discounted consequences of behavior change that give rise to moral hazard.

There is accumulating evidence that some of these unscreened academic programs are increasingly willing to accept higher risks from adverse selection and moral hazard because their operating budget is based on enrollment. Therefore, in the short term, tuition is a more urgent need than retention, graduation, and placement fees. The focus on enrollment is necessary but shortsighted and misguided because in practice these indices and benchmarks are interrelated, circular, and cumulative.

In the insurance industry, healthy insured women of childbearing age and healthy middle-aged women who subsequently seek creative ways to become pregnant experience adverse selection and moral hazard issues. Also, insurance applicants whose actual risks are substantially higher than the risks known to the insurance company are potentially interesting case studies. The insurance company suffers adverse effects by offering coverage with premiums that do not accurately reflect its actual exposure to risks.

Risk mitigation strategies and some practical guidance

Consult with a competent professional for specific advice. The following are general guidelines based on a review of existing academic literature, accumulated professional practice, and industry best practices. In summary, adverse selection and moral hazard arising from asymmetric information expose the parties to transactions to undue amounts of higher risk for which they do not receive adequate and adequate compensation. Therefore, it is essential that the parties take all possible measures to mitigate the risks of adverse effects derived from asymmetric information and the consequent decision failures.

Administrative economic principles and industry best practices suggest selection and classification to mitigate adverse selection and incentive contracts to mitigate moral hazard. In addition, it is strongly recommended to use strategic intelligence systems (SIS) that provide relevant, accurate and timely identification and quantification of risk factors.

In risk management, the use of aggregate liability limits and policy riders that outlaw material post-contract unilateral actions and limit aggregate financial risks for the parties is strongly recommended. Additionally, Device Disclosure, Discovery, Tracking, Random Inspection, and Verification are highly recommended.

Finally, because adverse selection derives from hidden characteristics and profiles and moral hazard derives from hidden actions, decision systems and strategic intelligence systems must be transparent and provide relevant, accurate and timely information to facilitate decisions based on the known probability of incidence and risk allocation between the parties to the transactions with due and adequate compensation.