Final answer:
Surplus lines insurance is typically for high risk individuals or entities that cannot obtain standard insurance. It addresses the issues of moral hazard and adverse selection, with high-risk individuals often paying higher premiums due to the greater likelihood of filing a claim.
Step-by-step explanation:
Surplus lines insurance typically involves insurance for high risk individuals or entities who are unable to secure insurance in the regular market due to the nature of their risk profile. The fundamental law of insurance dictates that a fundamental balance must be struck where the average person's insurance payments over time cover the person's claims, the costs of running the insurance company, and provide for the company's profits.
In the process of classifying risk groups, companies may encounter issues of moral hazard and adverse selection, both of which involve imperfect information. Moral hazard describes a situation where the behavior of an insured party changes as a result of having insurance, while adverse selection describes a scenario in which those most likely to file a claim are also the most likely to purchase insurance. These problems arise due to difficulties in accurately categorizing individuals into appropriate risk groups.
Risk groups are defined as groups that share roughly similar risks of adverse events occurring. In the context of surplus lines insurance, high-risk individuals or groups who are not able to get insurance through standard insurers are the ones who turn to the surplus lines market, where insurers can provide coverage for this non-standard, higher risk.