Final answer:
The concept of adverse selection in insurance markets is explained through a scenario where an insurance company is unable to distinguish between different risk levels among drivers, leading to loss of low and medium risk clients and financial losses due to only high-risk clients remaining.
Step-by-step explanation:
The question deals with the concept of adverse selection in insurance markets, demonstrating how it can disrupt the balance and sustainability of insurance premiums and coverage when there is asymmetric information between insurers and insured parties. In the provided scenario, an insurance company cannot differentiate between low, medium, and high-risk drivers among 100 individuals seeking automobile insurance.
This leads to premium pricing that causes low and medium risk individuals to opt-out, leaving the company with only high-risk clients causing significant financial losses. This is because the drivers have information on their risk levels that the insurance company does not, illustrating the challenge of adverse selection.