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Imperfect information is the cause of the moral hazard problem. If an insurance company had perfect information on risk, it could simply raise its premiums every time an insured party engages in riskier behavior. However, an insurance company cannot monitor all the risks that people take all the time and so, even with various checks and cost-sharing, moral hazard will remain a problem.

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The adverse selection problem

Adverse selection refers to the problem in which the buyers of insurance have more information about whether they are high-risk or low-risk than the insurance company does. This creates an asymmetric information problem for the insurance company because buyers who are high-risk tend to want to buy more insurance, without letting the insurance company know about their higher risk. For example, someone purchasing health insurance or life insurance probably knows more about their family’s health history than an insurer can reasonably find out even with a costly investigation; someone purchasing car insurance may know that they are a high-risk driver who has not yet had a major accident—but it is hard for the insurance company to collect information about how people actually drive.

To understand how adverse selection can strangle an insurance market, recall the situation of 100 drivers who are buying automobile insurance, where 60 drivers had very low damages of $100 each, 30 drivers had medium-sized accidents that cost $1,000 each, and 10 of the drivers had large accidents that cost $15,000. That would equal $186,000 in total payouts by the insurance company. Imagine that, while the insurance company knows the overall size of the losses, it cannot identify the high-risk, medium-risk, and low-risk drivers. However, the drivers themselves know their risk groups. Since there is asymmetric information between the insurance company and the drivers, the insurance company would likely set the price of insurance at $1,860 per year, to cover the average loss (not including the cost of overhead and profit). The result is that those with low risks of only $100 will likely decide not to buy insurance; after all, it makes no sense for them to pay $1,860 per year when they are likely only to experience losses of $100. Those with medium risks of a $1,000 accident will not buy insurance either. So the insurance company ends up only selling insurance for $1,860 to high-risk drivers who will average $15,000 in claims apiece. So the insurance company ends up losing a lot of money. If the insurance company tries to raise its premiums to cover the losses of those with high risks, then those with low or medium risks will be even more discouraged from buying insurance.

Rather than face such a situation of adverse selection, the insurance company may decide not to sell insurance in this market    at all. If an insurance market is to exist, then one of two things must happen. First, the insurance company might find some way of separating insurance buyers into risk groups with some degree of accuracy and charging them accordingly, which in practice often means that the insurance company tries not to sell insurance to those who may pose high risks. Or second, those with low risks must be required to buy insurance, even if they have to pay more than the actuarially fair amount for their risk group. The notion that people can be required to purchase insurance raises the issue of government laws and regulations that influence the insurance industry.

Questions & Answers

what is the meaning of function in economics
Effah Reply
Pls, I need more explanation on price Elasticity of Supply
Isaac Reply
Is the degree to the degree of responsiveness of a change in quantity supplied of goods to a change in price
Discuss the short-term and long-term balance positions of the firm in the monopoly market?
Rabindranath Reply
how are you?
can you tell how can i economics honurs(BSC) in reputed college?
through hard study and performing well than expected from you
what should i prepare for it?
prepare first, in psychologically as well as potentially to sacrifice what's expected from you, when I say this I mean that you have to be ready, for every thing and to accept failure as a good and you need to change them to potential for achievement of ur goals
parna kya hai behencho?
Hello, dear what's up?
good morning
pls, is anyone here from Ghana?
Hw s every one please
Ys please I'm in Ghana
what is firms
Anteyi Reply
A firm is a business entity which engages in the production of goods and aimed at making profit.
What is autarky in Economics.
what is choice
Tia Reply
So how is the perfect competition different from others
Rev Reply
what is choice
please what type of commodity is 1.Beaf 2.Suagr 3.Bread
Alfred Reply
what is the difference between short run and long run?
Ukpen Reply
It just depends on how far you would like to run!!!🤣🤣🤣
meaning? You guys need not to be playing here; if you don't know a question, leave it for he that knows.
pls is question from which subject or which course
Is this not economics?
This place is meant to be for serious educational matters n not playing ground so pls let's make it a serious place.
Is there an economics expert here?
Okay and I was being serous
The short run is a period of time in which the quantity of at least one inputs is fixed...
that is the answer that I found online and in my text book
Meaning of economics
Suraj Reply
It will creates rooms for an effective demands.
Chinedum Reply
different between production and supply
What is the economic?
Economics is a science which study human behavior as a relationship between ends and scarce means which has an alternative use.
what is supply
what is different between demand and supply
Debless Reply
Demand refers to the quantity of products that consumers are willing to purchase at various prices per time while Supply has to do with the quantity of products suppliers are willing to supply at various prices per time. find the difference in between
Please what are the effects of rationing Effect of black market Effects of hoarding
Atty Reply
monoply is amarket structure charecrized by asingle seller and produce a unique product in the market
Cali Reply
I want to know wen does the demand curve shift to the right
demand curve shifts to the right when there's an increase in price of a substitute or increase in income
ask me anything in economics, I promise to try and do justice to the question, you can send me an email or message, I will answer
what are the factor that change the curve right
explain the law of supply in simple .....
the Law of supply: states that all factor being equal, when the price of a particular goods increase the supply will also increase, as it decreases the supply will also decrease
@Nana the factor that changes or shift the d demand curve to the right is 1) the increase in price of a substitute good or commodity 2) increase in income
you can send your questions I am Comr. Kin chukwuebuka
different between bill of exchange n treasure bill
so would you tell me what means an apportunity cost plz?
what is true cost
your question isn't correct naadi
define an apportunity cost?
orukpe ,is my question whats wrong or u dont know anything?
In a simple term, it is an Alternative foregone.
opportunity cost is the next best value of a scale of preference
Both of you are not correct.
opportunity cost: is a forgone alternative
Monopoly is where is one producer produces a given product with no close substitute
what is income effect?
Qwecou Reply
if you borrow $5000 to buy a car at 12 percent compounded monthly to be repaid over the next 4 year what is monthly payment
Nitish Reply

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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