Final answer:
Insurance rates that do not accurately reflect expected losses lead to unfair discrimination. This can cause financial losses for insurance companies and discourage low-risk individuals from buying insurance, creating adverse selection issues.
Step-by-step explanation:
When insurance rates fail to equitably reflect the differences in expected losses and expenses, the result is unfair discrimination. This means that individuals or groups paying higher premiums do not accurately represent their actual risk levels. As a consequence, the insurance company may suffer considerable financial losses. If the company increases premiums to cover these losses, it could deter individuals with lower risks from purchasing insurance, potentially leading to a situation of adverse selection. In an ideally functioning insurance market, a company might find ways to accurately distinguish between various risk groups and charge them accordingly or ensure that those with lower risk are still inclined to purchase insurance, potentially through legal mandates.
Insurance functions as a method of sharing risk among a group, with the expectation that the premiums collected must on average not be less than the claims paid out. An actuarially fair insurance policy is one where the premiums match the average expected benefits. However, issues such as moral hazard, where insured individuals might take fewer precautions, and the notion of adverse selection, where high-risk individuals are more likely to seek insurance, can challenge the equitable and efficient operation of insurance markets.