Final answer:
The refusal of an insurance claim in the described situation is a consequence of adverse selection, which discourages low and medium risk parties from purchasing insurance and leads to financial losses for the insurance company when only high-risk parties are insured.
Step-by-step explanation:
The situation described where a company had goods lost by accident amounting to Rs 7000, but the insurance company did not admit any claim, can be explained by the concept of adverse selection. Adverse selection occurs when there is asymmetric information between the insurance company and the insured party. The insurance company tries to set premiums to cover expected losses, but if it cannot accurately differentiate between high-risk and low-risk clients, it ends up charging an average rate. This can discourage low or medium risk clients from buying insurance as it is not cost-effective for them, while the high-risk clients who buy the insurance will likely result in higher claims than the premiums can cover, leading to considerable losses for the insurance company.
As an example, consider an insurance market for automobile insurance with 100 drivers. Should the insurance company set a flat rate of $1,860 per year to cover averaged-out risk, those with low damages of only $100 would likely not purchase insurance. Ultimately, the insurer finds itself covering high-risk individuals more likely to claim large amounts, such as those with $15,000 in damages, which leads to financial strain on the company.