How do insurance companies address the issue of adverse selection?

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BlackTom AI · Accepted Answer

The prompt presents a question about adverse selection in insurance and, strangely, provides no answer choices to analyze.
To anchor the discussion, the stated correct idea is that adverse selection is addressed by insuring a large number of individuals. This aligns with foundational concepts in insurance: risk pooling and diversification reduce the impact of high-risk individuals disproportionately driving costs up for everyone else.
Consider why this approach helps: when an insurer covers a very large and diverse group, the average risk across the pool tends to stabilize due to the law of large numbers. Individual high-risk tendencies become less influential on overall premiums and losses, spreading costs across many policyholders rather than concentrating them on a few who are more likely to claim.
Now, imagine alternative or additional mechanisms that are often discussed in literature, even though they aren’t listed here. Underwriting and premium differentiation based on risk factors can help align prices with expected costs, but they can also reintroduce adverse selection if not applied broadly or transparently. Mandated or universal coverage can further counteract adverse selection by expanding enrollment beyond the high-risk segment, again supporting risk pooling. Community rating or experience rating frameworks are common tools; community rating reduces variance by charging similar premiums to all, which can attract low-risk individuals and overweight high-risk ones if not balanced by other controls.
If there were multiple options, you would evaluate each in light of how it impacts the balance between high-risk and low-risk participants and the size and composition of the insured pool. A correct choice would typically emphasize expanding the pool size and spreading risk broadly so that the average cost per policy remains stable and predictable.
In the absence of provided alternatives, the central takeaway is that insuring a large number of individuals strengthens risk pooling, mitigates the impact of adverse selection, and helps stabilize premiums for the insurer and the insured.

ECON 3190-090 Summer 2025 Quiz 3

How do insurance companies address the issue of adverse selection?

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ECON 3190-090 Summer 2025 Quiz 3

How do insurance companies address the issue of adverse selection?

View Explanation

Log in for full answers

Similar Questions

What theoretical problem does asymmetric information create in loan sales?

Question29 There is adverse selection into credit when the lender cannot screen good borrowers from bad due to lack of information True False ResetMaximum marks: 1 Flag question undefined

Which of the following statement about adverse selection is TRUE?

Part 1Which problem of asymmetric information are prospective employers trying to solve when they ask applicants to go through a job​ interview? A. Moral hazard in equity contracts. B. ​Free-rider problem. C. Adverse selection problem. D. Moral hazard in debt contracts.

More Practical Tools for Students Powered by AI Study Helper

Making Your Study Simpler

Part 1Which problem of asymmetric information are prospective employers trying to solve when they ask applicants to go through a job interview? A. Moral hazard in equity contracts. B. Free-rider problem. C. Adverse selection problem. D. Moral hazard in debt contracts.