Final answer:
Adverse selection leads to market failure in private annuities markets as individuals with longer expected lifespans purchase annuities more than those with shorter lifespans, causing insurers to face higher than anticipated payouts. This problem provides a rationale for systems like Social Security, which mandates participation, spreading the risk across the entire population. The correct answer is option b.
Step-by-step explanation:
Adverse selection in the private annuities market contributes to market failure due to asymmetric information between insurers and buyers, resulting in a discrepancy in the assessment of risk. Specifically, the correct answer to the question posed would be: b. The fact that people know more about their potential life expectancy than insurers do entails that a disproportionately large share of buyers will live relatively long lives after retirement.
Individuals with knowledge of their longer life expectancy are more likely to purchase annuities, expecting to benefit more from the payouts over time. Conversely, those who anticipate a shorter life span may avoid buying annuities, leading to a pool of annuity holders who, on average, live longer than the general population. Hence, this adversely impacts the annuity providers, as the cost to cover these long-lived individuals often exceeds the anticipated payouts, making it hard for private insurance markets to set fair premiums for everyone, and potentially resulting in market failure.
Social Security, provided by the government, acts as a buffer against this by mandating participation, thus diluting the risk across the entire population and not just those who opt in due to a high risk of living longer post-retirement.