Define the term adverse selection. Why is an insurance company unable to offer fair odds when it faces an adverse selection problem? How might the insurance company deal with an adverse selection problem?
What will be an ideal response?
Adverse selection occurs when fair odds are different for different people, but the insurance company is unable to distinguish people who are good risks from those who are poor risks. If the insurance company offered fair odds to everyone, then poor risks would purchase the policies designed for good risks and bankrupt the insurance company. The insurance company can deal with this adverse selection problem by limiting the amount of insurance that can be purchased at odds appropriate for good risks. In this situation, poor risks would find that they are better off purchasing unlimited amounts of insurance at the appropriate odds instead of a limited amount of insurance at more favorable odds.
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