Adverse selection is a term commonly used in economics, insurance, and risk management. It is a situation that arises when two engaging parties have different or asymmetric information. The situation becomes biased when participants from one of the parties who know more than the other exploit this private information to act optimally based on their own self interest. Adverse selection situations usually result to the other party’s disadvantage or cost.
Adverse selection risk
Adverse selection puts one party at risk or at a higher risk than normal. If one of the parties involved assumes that adverse selection is highly probable, it can affect their overall participation negatively, which will affect the project, initiative, company, or market. The danger of adverse selection, a situation based on hidden information, has the tendency to progressively spiral out of control until it has totally debilitated its environment.
Project management defines risk as an event that might happen, and if it does, might have a positive or negative impact. Some types of project risks are cost risk, schedule risk, and performance risk. When one party—for example, users, clients, contractors, or vendors—are deliberately not disclosing information, their action or inaction aids in the crafting of a poor cost estimate, schedule slippage, or failure to achieve project specifications.
Risk management process
Risk analysis and management is an important project management practice, one of the ten knowledge areas of project management according to the PMI. It is the process of identifying, analyzing, and responding to risks that arise during the lifecycle of a project. Risks have three elements: the event, the likelihood of the event occurring, and the consequence of the event occurring. All three must be clearly defined before the process of identifying risks is started.
Risk management helps categorize risks. Some risks are known risks, and they are evident early in the project planning phase. Adverse selection is an unknown risk, since only the party withholding the information knows of it, and it is not recognized in the project planning phase.
Steps to minimize adverse selection risk
It is important to establish a risk management process since projects inherently come with risks. A risk management plan must include at least the following major processes:
- Risk identification
- Risk evaluation or assessment
- Risk handling or response
- Risk monitoring and control
- A feedback loop or iterative process to ensure risk management is continuous
Methods to minimize adverse selection risk
Since adverse selection exists because of information asymmetry, there are specific ways to deal with it to narrow the gap of missing information. One way is to make sure that everyone is a stakeholder. When one party negatively affects the successful execution and delivery of a project, it must be clear that they are partly responsible and will not realize the value and benefits of the project.
Another way is by getting valuable information directly from other sources, such as statistics, previous projects, and relevant documents. Unfortunately, these steps do not actually make the other party share information to reduce the asymmetry. In other fields such as insurance, other methods are used to resolve asymmetric information.
Appraisal involves examining a characteristic (or a vital project requirement) and verifying it through a reliable assessment. If the information has a financial value, it can be assessed or verified by a certified professional.
Signaling is a method of obtaining indirect information based on how the other party treats an asset. Obtaining reliable reports to verify information about the asset is key to this method.
Screening is another indirect method where the party with less information identifies a key variable that leads the party hiding the information to reveal it. The more variables are identified, the more accurate the information will be.
Using a risk management process is not a guarantee that the project will go as planned without issues. But it can help avoid problems or reduce the consequences if those problems occur. Using project management software is one way to support project risk management in the organization. Furthermore, your PM software becomes the repository of your project documents, success reports, and lessons learned.