The market for "Lemons", Insurance and Nobel Prize in Economics
Vivek Sharan
Head of Marine-UAE | Marine Insurance | Ex-Mariner | Doctoral Student-Economics & Public Policy
In the 1970s three researchers, George Akerlof,?Michael Spence?and?Joseph Stiglitz set the foundations of what is now known as the "theory of markets with asymmetric information". They received the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel, 2001, “for their analyses of markets with asymmetric information”.
There are some markets which by their very design tend to have a higher level of information asymmetry compared to others. Three examples of such markets are :?
One key reason why such asymmetry of information in a market exists is when "agents" on one side of the market have much better information than those on the other side.
"Agent" here means "An Economic Agent"?
In economics, an agent is an actor in a model of some aspect of the economy. These agents are?consumers, producers, and/or influencers of capital markets and the economy at large. There are four major economic agents: households/individuals, firms, governments, and central banks.?
“The Market for Lemons” by Akerlof, published in 1970, is the single most important study in the literature on the economics of information. In this essay, Akerlof introduces the first formal analysis of markets with the information problem known as adverse selection. He analyses that in a market where "sellers" (example sellers of risk: policyholders) have more information than the buyers of risk (example: Insurers), " information problem" can cause an entire market to either collapse or contract it into an adverse selection of low-quality products or players.
In the last three years, we have seen various insurers, reinsurers exiting partly or completely from underwriting in a particular geography. Part of the problem can be attributed to the information problem of adverse selection. Due to imperfect information on the part of insurers, over a period of time, agents with lower quality on either side of the market crowd out the market where serious and quality players end up being forced out of the market.?( There are however other factors at play as well.)
To address this problem of "adverse selection" as identified by "George Akerlof" in a market with "information asymmetry", Michael Spence and Joseph Stiglitz developed their theory on "Signal" and "Screening" respectively.??
Michael Spense asked how better-informed individuals on a market can credibly “signal”, their information to less informed individuals, to avoid some of the problems associated with adverse selection. In the context of insurance, policyholders (better informed economic agents) can signal key information to Insurers (less informed economic agents), even if such information is not mandatorily required by insurers. Such information can be risk improvement measures, quality control and overall individual / corporate strategy towards risk management. The role of an insurance broker/advisor becomes extremely crucial in signalling this information to the insurer. Insurance brokers understand the industry standards and what will help insurers differentiate between so-called colloquial good and bad "lemons"??
Spense further highlighted that signalling requires economic agents to take observable and costly measures to convince other agents of their ability or, more generally, of the value or quality of their products. A fundamental insight from Spence’s pioneering essay from 1973 is that signalling cannot succeed unless the signalling cost differs sufficiently among the “senders”. In the context of insurance, it is apparent that policyholders who have well-crafted risk management procedures can signal the good quality of their risk profile at a fractional cost in comparison of those policyholders who tend to have substantially higher risk profiles.?
One of Stiglitz’s classical papers, coauthored with Michael Rothschild, formally demonstrated how information problems can be dealt with in insurance markets where the companies do not have information on the risk situation of individual clients. Rothschild and Stiglitz showed that the insurance company (the uninformed or less-informed party) can give its clients (the informed party) effective incentives to “reveal” information on their risk situation through so-called?"screening".?
Insurance companies can use "screening" by offering policyholders to choose from a menu of alternative contracts where lower premiums can be exchanged for higher deductibles. For example by choice of a contract with higher deductibles, policyholders "self-screen" and put themselves under the category of low risk (likely because of their better risk management procedures). On the other hand, typically policyholders with higher risk profiles will opt for lower deductibles. Along with deductibles, insurers can also use different types of variations in conditions and policy wordings to allow self-screening by offering such options to their policyholders.?
Two other researchers who are certainly worth mentioning here are James A. Mirrlees and William Vickrey who received the Nobel Prize in 1996 for their fundamental contributions to the economic theory of incentives under asymmetric information.
They proposed that incomplete and asymmetrically distributed information has fundamental consequences, particularly in a way that an informational advantage can often be exploited strategically. An insurance company cannot fully observe policyholders’ responsibility for insured property and external events which affect the risk of damage, causality etc.
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Mirrlees’s approach has become extremely valuable in situations where it is impossible to observe another agent’s actions, so-called?moral hazard.
Moral Hazard is one of the prominent problems in Insurance. It is not only difficult to monitor but extremely costly to administer. Mirrlees paved the way for increasingly powerful analysis. He noted that an agent’s actions indirectly imply a choice of the probabilities that different outcomes will occur.
The conditions of optimal terms and conditions of compensation provide indirectly the " probability information" about the agent's choice and the information about how much the insurance protection needs to be restricted to provide the agent with suitable incentives. These incentives are stipulated in an insurance contract; the agent bears part of the cost of undesirable outcomes or receives part of the profits from favourable outcomes. The policyholder takes care of the insured object almost as if it were uninsured.
The research around asymmetric information indeed extends to many sectors beyond insurance. However, the application of similar research in the field of insurance seems to be certainly interesting. Insurance is one of the very few sectors where the asymmetry of information between the two agents is profound and has far-reaching implications.?
(Note: This is an oversimplified summary of the research done in this field. For a detailed study please refer to the links and references below )
References:
Akerlof G. (1970), “The Market for Lemons: Quality Uncertainty and the Market Mechanism”,?Quarterly Journal of Economics?84, 488-500.
Riley, J. (2001), “Silver Signals: Twenty-Five Years of Screening and Signaling”,?Journal of Economic Literature?39, 432-478.
Rothschild M. och J. Stiglitz (1976), “Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information”,?Quarterly Journal of Economics?90, 629-649.
Spence M. (1973), “Job Market Signaling”,?Quarterly Journal of Economics?87, 355-374.
Stiglitz, J. (1997), “Economics”, 2nd edition, W. W. Norton (New York).