Final answer:
Subjective and objective risk differ because individual perceptions and measurable risk factors are not always aligned, with subjective risk influenced by personal experience and biases, while objective risk is based on empirical data. Challenges in insurance, such as moral hazard and adverse selection, result from imperfect information in categorizing individuals into risk groups. Insurers must contend with the complexity and uncertainty inherent in predicting future events and individual behaviors.
Step-by-step explanation:
Subjective and objective risk may differ due to the differences in individual perceptions and measurable risk factors. Subjective risk encompasses a person's personal opinion and feeling towards the likelihood of an event occurring, which can be influenced by past experiences, emotions, and cognitive biases. For instance, a driver who had a major accident may consider themselves low-risk if they believe the accident was an outlier, while the insurance company may evaluate this incident as an indication of high risk based on statistical data and actuarial calculations.
Imperfect information in insurance markets creates challenges like moral hazard and adverse selection. Moral hazard occurs when there is an incentive to take on risks because the consequences are borne by others, whereas adverse selection arises when those at high risk are more likely to apply for insurance than those at low risk. Both issues stem from the problem of categorizing individuals into risk groups using imperfect information.
Additionally, imperfect information affects insurance as we cannot predict future events with certainty. While empirical data can provide probabilities, individual risk assessment is complex due to variations in behavior and chance events. Insurers strive to balance the need for fair categorization with the reality of unpredictable human behaviors and outcomes. This balance is at the core of the differences between subjective and objective risks.