Final answer:
True, underinsurance poses a significant challenge for both policyholders, who may face financial difficulties due to inadequate coverage, and insurers, who deal with adverse selection and imperfect information leading to increased costs and market inefficiencies.
Step-by-step explanation:
True. Underinsurance is indeed a serious problem for both insurers and the insured. For those holding insurance policies, underinsurance means they do not have enough coverage to fully protect against losses. This can lead to significant financial hardship in the event of accidents or illnesses.
Insurers face challenges when high-risk individuals purchase insurance while low-risk individuals opt out, a phenomenon known as adverse selection. Subsequently, insurers experience increased costs, which can compel them to raise premiums.
As premiums rise, fewer individuals may be able to afford insurance, worsening the problem of underinsurance. Furthermore, imperfect information makes it difficult for companies to accurately price risk, leading to potential losses.
Historical data indicates the gravity of the situation, showing that underinsurance contributes to financial distress, such as bankruptcies due to medical expenses. Additionally, the difficulty insurers have in assessing individual risk, partly due to policyholders having more information about their risk level than the insurer, aggravates the issue of underinsurance.
The dynamic of imperfect information in insurance markets ultimately results in less efficient markets and presents a problem for all parties involved.