An article in the Economist referred to “the basic logic of the insurance industry – that...

An article in the Economist referred to “the basic logic of the insurance industry – that it is impossible to predict who will be hit by what misfortune when, and that people should therefore pool their risks”. In what sense does insurance involve pooling risks? How does the problem of adverse selection affect the ability of insurance to provide the benefit of pooling risk? Explain.

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Expert Solution

Insurance companies pool risk by combining together many different individuals with different risks in order to compensate the risk taken for covering high risk individuals by taking into the pool low risk individuals. This pooling of individuals with different risk structures, helps the insurance companies spread risk through pooling.

Adverse selection refers to the situation in which due to lack of complete information, insurance companies end up providing high insurance coverage at low premiums to high risk individuals.

For e.g. an individual with poor past medical history might end up getting insurance at good premium.

In case of adverse selection, benefit from risk pooling, for the individual gets reduced, as his risk increases and thus cost to be borne increases.

Rahul Sunny answered 1 year ago

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