Final answer:
The size of the loss in terms of dollars lost per claim in the insurance industry is known as Severity. High-severity claims lead to higher costs for the company, and charging average premiums can result in adverse selection, where high-severity claimants are more likely insured, increasing the financial risk for the insurer.
Step-by-step explanation:
The term used to describe the size of the loss in terms of dollars lost per claim is called Severity. In the context of insurance, severity affects the cost of claims to the insurance company. If an insurance company experiences high-severity claims, this means that the claims will be expensive on a per-claim basis. For example, if drivers in an insurance pool experience accidents that cost significantly different amounts to cover, and the insurance company sets the premiums based on an average cost that does not accurately reflect each driver's risk, the situation may lead to adverse selection. Adverse selection occurs when those with higher risks of claims are more likely to purchase insurance, while those with lower risks opt out, leaving the insurer with a disproportionate number of high-risk policyholders and potentially significant financial losses.
If the insurance company tries to charge the actuarially fair premium to the group as a whole rather than pricing each risk group accurately, it may result in a miscalculation where low-risk individuals choose not to buy insurance at the higher average rate. Over time, this may lead to the insurer covering mostly high-risk drivers and facing considerable financial challenges as the average claim's severity is much higher than the premiums collected.