Question

A dental insurance company charges premiums higher than average dental costs across a population and loses money. When it keeps raising the premiums on its policies, its losses keep rising. The dental insurance company is facing

a. sellers with diminishing market power.
b. the challenge of having private information not known by the buyers.
c. an adverse selection death spiral.
d. the challenge of high growth of demand.

Answer 1

The dental insurance company is facing an adverse selection death spiral, where charging higher premiums discourages low and medium-risk individuals from buying insurance. This leads to increased losses for the company. The company can try to separate buyers into risk groups or government laws and regulations can influence the insurance industry to address this issue. The correct answer is option c.

Step-by-step explanation:

The dental insurance company is facing an adverse selection death spiral. Adverse selection occurs when insurance buyers have more information about their risk level than the insurance company. In this case, the company is charging premiums higher than average dental costs, which discourages buyers with low or medium risks from purchasing insurance. As a result, the company is left with a pool of high-risk individuals who are more likely to make claims, leading to increased losses for the company.

If the insurance company continues to raise premiums to cover these losses, it will further discourage low and medium-risk individuals from buying insurance, worsening the adverse selection problem. To address this issue, the company could try to separate buyers into risk groups and charge them accordingly. However, this may result in the company avoiding high-risk individuals altogether, or low-risk individuals paying more than they should.

Government laws and regulations could also play a role in influencing the insurance industry and addressing adverse selection and moral hazard problems.