Final answer:
ABC Insurance uses risk classification to manage adverse selection and moral hazard by charging premiums that are actuarially fair. However, determining individual risk levels can be controversial, particularly when past accidents are used as a predictor of future risk.
Step-by-step explanation:
ABC Insurance must employ a technique that assigns value to different levels of risk to ensure that the insurance market remains viable amidst challenges such as adverse selection and moral hazard. The company may separate insurance buyers into risk groups and charge them based on the expected losses. This process, involving actuarially fair premiums, ensures that individuals pay charges commensurate with their risk level. However, this can be controversial when past incidents influence risk classification.
For instance, a driver involved in a major accident might be seen as high-risk, which could lead to higher insurance premiums. In contrast, that same driver might argue the accident was a stroke of bad luck and therefore might seek to be classified as low-risk, deserving of a lower premium. The delineation between risk groups is a delicate balance between representing statistical realities and individual circumstances, where government laws and regulations may also play a significant role.