Final answer:
When a producer takes an insurance application, information asymmetry between the insurer and the insured can lead to adverse selection if an actuarially fair premium is charged to the group as a whole.
Step-by-step explanation:
When an insurance application is taken by a producer, certain truths about the asymmetry of information between the insurer and the insuree come into play, particularly in the areas of life insurance and car insurance. An individual looking to purchase life insurance typically has more in-depth knowledge about their family's health history than an insurance company can feasibly discover without extensive and often expensive research. Similarly, someone obtaining car insurance may be aware of their own high-risk driving habits that have yet to result in a major accident - information which can be challenging for an insurance company to ascertain accurately.
Given this information asymmetry, if an insurance company attempts to charge an actuarially fair premium to a group as a whole, rather than to individuals based on their specific risk factors, it may find itself in a situation of adverse selection. Adverse selection occurs when the insurer is unable to distinguish between high-risk and low-risk insurees, leading to a scenario where high-risk individuals are more likely to purchase insurance at prices that are not commensurate with their actual level of risk. Consequently, the insurer may incur losses or be forced to raise premiums for all insurees, which can then push low-risk individuals out of the market, further exacerbating the issue.
To mitigate the potential impacts of adverse selection, an insurance company may need to either find a method of accurately classifying buyers into risk groups and adjust premiums accordingly or require that all individuals, regardless of risk level, purchase insurance. This latter approach can mean that lower-risk individuals will end up paying more than what would be considered actuarially fair for their group. Such necessity sometimes leads to regulations mandating insurance purchase, which introduces its own set of complexities into the insurance market.