Adverse Selection in Relationship Markets

Adverse Selection is the name for a common syndrome in markets where “market participation is a negative signal.”  For example: life insurance office, enters the husband and he announces: “Quick, I need a million dollar life insurance policy on my wife; by 6:45 this evening!”  The agent thinks: “Yeah, quick commission!  Ka-Ching!”  Off stage the insurance company notes both agent and husband’s particpation in this insurance market are signalling a negative.  Adverse selection.

Markets can be structured to encourage adverse selection.  When the guy in the plaid suit swoops down on you in the parking lot most of us think “oh dear, here comes the salesman” but the sophisticated observer of markets thinks: “adverse selection.”  When a car company announces that their sales people aren’t paid a commission they are trying to signal the absence of this problem.

When the mortgage industry rejiggered their risk management architecture they created a market with an abundance of adverse selection.  The mortgage brokers were encouraged to ask few questions while gathering their commissions.  Mortgage buyers where invited to murder their financial lives.  Apparently the entire hierarchy of this financially innovative market encouraged adverse selection and everybody’s participation was a negative signal.

Insurance contract often have clauses to temper the problem of adverse of selection.  If you die shortly after buying a life insurance contract they will take a close look at that clause.  The preexisting condition clauses in health insurance contracts are mutant versions of these.  Horrible horrible stories are common, insurance companies abusing these clauses to claw their way out of their contracts.  But notice how any market with even a wiff of the taint of adverse selection problem suffers another problem.

If you go to bar, or sign up for a dating site, or even sign up for a course at night school your entering a market for new relationships.  Such markets are riff with adverse selection problems.  So by walking thru the door you immediately become suspect.  Your participation in the market is a negative signal?  Who are these losers?  In the healthcare debate the reluctance of optimistic healthy people to participate in the market would seem to have a bit of that.  I.e. they aren’t just suffering from a naive misunderstanding about time, they are also reluctant to hang out with all those sick losers.  It’s not just “I’m healthy I don’t need insurance, it’s I don’t want to be associated with that kind of people.”

All the markets for creating new relationship have serious adverse selection problems; e.g. consulting, sales, hiring.  The problems are greater the longer term the relationship is going to be.

Hiring is a great example.  If you list an opening anybody who applies is immediately suspect; particularly if they are unemployed.  Their participation in your hiring process is a negative signal.  This signal is probably more accurate when the economy is strong and applicants are few, but ironically when the economy is weak and the applicants are numerous then the need for a cheap rule of thumb for sorting the applicants increases.  Here’s a nice article (thanks Luda)  about this syndrome.  The HR or head hunter jargon for this problem – two words: actives and passives.  Anybody who is actively looking is immediately suspect.

This is the Groucho Marx story:  “I sent the club a wire stating, Please accept my resignation.  I don’t want to belong to any club that will accept me as a member.”

Since adverse selection taints relationship building markets you get a plethora of work arounds.  There is demand for faux passivity.  Eight percent of the folks at the evening drawing class maybe looking for a relationship, but the twenty percent who are there to learn a new skill provide a plausible cover story.  Most of the folks in the bar maybe looking for new relationships, but if they can get a gaggle of their existing friends to head out to the bar with them then they have a good cover story.  No doubt with a little effort you can think of lots of activities that include in their value proposition a dose of faux intended to treat the problem of adverse selection in relationship building.

The problem is perfectly symmetric.  These days you see lots of job listings that read along these lines: “paid opportunity!” or “grow into in-house and salaried positions” or “great resume experience”.  Once you start thinking that every posting is a negative signal about the company in question it really changes the way you read the postings.  And amazingly you can almost always see why this one is a looser.  For example doesn’t this: “report directly to the _ and _ and work alongside _” raise a bit of concern?  I suspect they mentioned that in the posting because it’s a problem and hence it is – more than you know – part of the job description.  I worked for one large institution that had a policy that they would absolutely never pay for job listings – I now think that reflected their deep seated desire to never look so desperate as to be actively seeking a relationship.

Middlemen provide one way to tackle the adverse selection problem.  If I need to fill a position I’d rather, given the above, avoid the job posting markets.  So I go to my social networks, or I go to a professional headhunter.  I find that fascinating.  I’d noticed before how the middleman is two-faced – offering one face to each side of the transaction he is intermediating.  But this high lights another kind of duality in the middleman’s role.  He is at one and the same time offering a service that tempers the market failures due to adverse selection while at the same time his incentive is that ka-ching of closing the deal.

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