What is Screening?
Screening refers to a strategy that is used to combat adverse selection by filtering out false information and retaining only the true information. Screening is used in contemporary markets where the products being released into the market are getting increasingly complex for an ordinary consumer to comprehend.
For example, in the auto industry, non-specialist buyers rely on the information provided by the seller when evaluating the type of car they want to buy. Since the specialist seller possesses more information than the buyer, he or she may give false information about a product in order to convince the buyer to purchase that item instead of another. Screening is employed in various areas, such as insurance, job markets, and management, where the problem of asymmetric information exists.
What is Asymmetric Information?
Asymmetric information exists when one party in a transaction possesses better information than the other party. In certain industries, some parties in a transaction are bound to know more than other parties in the same transaction.
For example, in a sale transaction, sellers are bound to have more information than the buyers, since dealing with the same product or a range of products gives them greater knowledge of the product compared to the knowledge that some buyers have.
Screening is used when asymmetric information may lead to a moral hazard or adverse selection due to information imbalance. The concepts are explained below:
Moral hazard occurs when one party changes behavior in a way that causes harm to another party. It is common in the insurance industry where one party engages in risky behavior because they have purchased insurance coverage and will be compensated if the asset insured is damaged or involved in an accident.
The insured party engages in risky behavior without the knowledge of the insurer. The insurance company can identify such customers by screening them during registration so that persons with a history of such risky behavior can be excluded or given a different insurance plan that can accommodate the high level of risk.
Adverse selection occurs when parties in a transaction are able to use their knowledge about a product to maximize their outcomes. Unlike moral hazard, adverse selection occurs before the parties have entered into an agreement.
For example, in a sale transaction, the buyer has less information, and, therefore, offers a lower price for the good, and the seller in return offers lower quality goods that are equal to the price that the buyer is offering. Screening can help the buyer obtain more information about the product, and therefore know the right price for the product, and how to distinguish between a high-quality product and a low-quality product.
Screening Techniques Used in the Labor Market
There are several techniques that employers use to address the problem of asymmetric information among interview candidates. The techniques include:
1. Aptitude tests
Aptitude tests are one of the most popular screening techniques that employers use to select high-quality candidates from a pool of job seekers. Aptitude tests are usually in the form of specialized tests that are used to test a candidate’s productivity and their knowledge of specific subjects.
2. Quality of college or university
Employers also use the candidate’s school affiliation to shortlist candidates. They assume that the top-tier colleges and universities produce high-quality candidates who are likely to outperform candidates from the other colleges.
3. Grade Point Average (GPA)
The average grade points achieved during the years spent in school can also be used to screen potential employees. The top performers who have performed consistently well in school will have high averages compared to students who have had varied performances during their years in school.
Screening Techniques in the Insurance Industry
Asymmetric information also exists in the insurance industry, and it often leads to moral hazard among the insured persons. Some of the techniques that insurance companies use include:
1. Historical record
Insurers look at the past behavior of its insurance clients to determine their level of risk and the possibility that they will engage in risky behavior in the future. For example, if a client has a history of multiple car accidents in the past, there is a likelihood that the client will still get involved in an accident in the future. It makes the insurance company aware of the level of risk that it is subjecting itself to by providing insurance coverage to the risky client.
2. Health condition
When providing life insurance coverage to a client, the insurer will be interested in knowing the health condition of the client and the kind of illnesses that the person has. Clients with terminal illnesses or other long-term illnesses are usually categorized as risky and are, therefore, charged different premiums compared to clients with no history of illnesses.
3. Demographic characteristics
Another consideration that insurance companies make is looking at the demographic characteristics of its new clients. When selling auto insurance, younger clients in the 13- to 20-year-old bracket are considered risky compared to the clients in the 40- to 50-year-old age bracket. On the other hand, older clients aged above 60 years old are considered risky compared to younger clients aged 30 to 40 years old in life insurance.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful: