Question

Suppose an insurance company knows that there are two groups on the demand side of the market, the careful and the careless. It has good estimates of the probability a person in each group has an accident, but it cannot identify who is in which group. The company charges a premium based on the average probability of an accident. Most likely, the share of buyers who are in the careless group will be disproportionately:

A) Higher, and the company will overcharge the careful group.
B) Lower, and the company will overcharge the careless group.
C) Higher, and the company will undercharge the careful group.
D) Lower, and the company will undercharge the careless group.

Answer 1

Due to adverse selection, the insurance company will end up with a disproportionately higher share of careless drivers because it charges premiums based on the average probability of accidents. Careful drivers are overcharged and may buy less or no insurance, while careless drivers are undercharged and have an incentive to buy more.

Step-by-step explanation:

When an insurance company cannot differentiate between the careful and the careless due to imperfect information, and it decides to charge a premium based on the average probability of accidents, the outcome is often a classic case of adverse selection. Those who are careful are likely to be overcharged relative to the risk they present, and thus, may opt out of the insurance or buy less of it. On the other hand, the careless, who are undercharged relative to their risk, would have a greater incentive to buy the insurance. The share of buyers who are in the careless group will be disproportionately higher, and the company will undercharge the careful group, leading to option A) Higher, and the company will overcharge the careful group.