Risk Environment Part 1: How to Turn the Concept of Adverse Selection to Actionable Accountability

Header image. A person in a suit is stacking Jenga blocks, which appear to possibly fall over at any moment.

By Allied Solutions | January 11, 2023


Recent economic conditions have significantly increased the likelihood of adverse selection. 

But what will separate FIs that thrive from those that merely survive? Informed risk management.

Informed risk management requires a data-driven understanding of how much adverse selection is in your portfolio. Successful (read: thriving) institutions closely monitor changes in their adverse selection and adapt risk controls and underwriting policies to mitigate the greatest risk areas.

The right analytics and insights enable lenders to anticipate and brace for impact under various economic scenarios. This is accomplished by calculating a data-intensive index that quantifies the unexplained risk, making actions to mitigate far more meaningful. There is hidden behavioral risk in portfolios exacerbated by recent interest rate increases to fight inflation. Because of this approach, (data at scale and predictive forecasting) calculations, quantifications, and proactive actions can reduce risk and improve returns.

Unexpected levels of consumer savings and price shocks from supply chain constraints led to a spike in inflation. In response, the Federal Reserve raised interest rates. Rising prices for major purchases and rising costs of financing push the “value shoppers” out of the lending market and those still in the market have a higher appetite for risk or have no other choice; in other terms, higher-risk borrowers. These personality traits are not captured by traditional measures like FICO and LTV, leaving lenders unaware or unprepared for future losses. 

With appropriate analytical tools, lenders can become aware early of these emerging risks. Early warning measures allow for adjustments to collections policies and loss reserves for the loans already booked and modifying underwriting policies and terms for future originations. Responding to adverse selection requires a segment-level review to tighten criteria where appropriate and shift loan terms to reduce yield risk.


Now what? 

Protecting your financial institution requires the right analytics and insights to proactively understand the impact of adverse selection on your portfolio. Financial institutions need to assess borrower impact, indebtedness, and how much risk, as a lender, you have on the books. 

To do this, financial institutions will need to be diligent in proactively partnering. This means doing your homework and starting with discovery. Develop evaluation criteria, research, ask questions, and compare results. A true partner will listen to and understand your concerns to formulate a right fit solution with unrivaled data pools for proven accurate predictive forecasting. Successful solutioning criteria should offer a wide variety of inclusions specific to the following areas:

3 key considerations for predictive forecasting. First, leverage adverse selection models. Second, integrate economic forecasting and stress testing. Third, optimize credit boxes to enhance lending.

  1. Leverage Adverse Selection models that can help you proactively change price, policies, and reserves
  2. Dynamically integrate economic forecasting and stress testing in real-time to evaluate future performance through favorable and unfavorable conditions
  3. Optimize the credit box for profitability and enhanced lending


Take Action

Once the extent of the risk carried is determined, it’s time to focus on how to protect your institution and those you serve while remaining compliant. The CFPB evaluates fairness in lending with respect to borrowers of poor credit quality and predatory practices. When borrowers are in the higher risk category, raising rates is standard, but it must be in proportion to the risk. Be sure to use forward-looking yield estimates to quantify additional pricing driven by increased risk. Adverse selection estimates have the ability to justify to regulators the higher pricing and higher loss reserves that lenders need today. 

Now is the time to strategically select and execute an integrated Predictive Forecasting technology solution that fortifies your market positioning and augments key business initiatives towards Revenue Growth, Risk Management, and Business Diversification to safeguard the current and future success of your financial institution.

Watch for Risk Environment Part 2: Leveraging your CELC Journey for Continued Success


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About Allied Solutions
Allied Solutions is one of the largest providers of insurance, lending, risk management, and data-driven solutions to financial institutions in the US. Allied Solutions uses technology-based solutions customized to meet the needs of 4,000 banks and credit unions, along with a portfolio of innovative products and services from a wide variety of providers. Allied Solutions is headquartered in Carmel, Indiana and maintains several offices strategically located across the country. Allied Solutions is a wholly owned and independently operated subsidiary of Securian Financial Group.

Content in the blog posts are the opinion and views of the writer, and don't necessarily reflect the opinions or views of Allied Solutions.

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