Question

Why must insurance companies screen applicants so carefully?

Answer 1

This is a case of asymmetric information. Insurance companies have less information regarding the health status of people as compared to the people themselves. So, this creates the problem of adverse selection in which people with worse health conditions are more likely to buy insurance. However, this increases the cost of insurance when people with bad health or preexisting conditions are offered insurance or covered with a lower premium. If insurance companies extend insurance to people with bad health, the chances are that the company might underestimate the cost of insurance and charge a lower premium. This is why insurance companies screen applicants so carefully to avoid the problem of adverse selection.