Questions: Adverse Selection

Question 1

In the classic adverse selection insurance model, why does a single pooling contract (priced at average risk) tend to be unstable?

• A. High-risk types refuse to buy insurance at any price
• B. High-risk types over-buy while low-risk types drop out, raising average claims above the pooled premium
• C. Low-risk types voluntarily cross-subsidize high-risk types
• D. Regulators prohibit average-cost pricing in insurance markets

Answer: (B)

At a premium reflecting average risk, the contract is a good deal for high-risk individuals (who expect to collect more than they pay) but overpriced for low-risk individuals (who expect to collect less). Low-risk types exit, leaving a riskier pool. The insurer must raise premiums to cover actual costs, which drives out more low-risk types — a death spiral. This adverse selection dynamic is why a single pooling contract is unstable in competitive markets.

Question 2

Adverse selection is a pre-contractual problem (hidden type), while moral hazard is a post-contractual problem (hidden action).

• T. True
• F. False

Answer: True

Adverse selection arises from private information that exists *before* contracting — the informed party's type (risk level, quality, ability) influences who self-selects into the contract. Moral hazard arises *after* the contract is signed, when the insured party changes their behavior because they are now protected. Both are asymmetric information problems, but the timing and the nature of the hidden information differ fundamentally.

Question 3

What is a separating equilibrium in the context of adverse selection, and why does it solve the information problem?

Model answer: A separating equilibrium is a menu of contracts designed so each type of agent self-selects the contract intended for them. High-risk types choose the full-coverage, high-premium contract; low-risk types choose a partial-coverage, low-premium contract — and neither type wants to mimic the other. The uninformed party (insurer) can then infer each agent's type from their contract choice, effectively revealing the private information through incentive-compatible design.

The key mechanism is that the low-risk contract must be distorted — less than full coverage — to make it unattractive to high-risk types who would otherwise mimic low-risk buyers. This distortion creates an efficiency loss (low-risk types are under-insured relative to the full-information optimum), which is the unavoidable cost of screening under asymmetric information.