Which approach is listed as a solution to adverse selection?

Which approach is listed as a solution to adverse selection?

• A. Break people into groups
• B. Increase the overall premium for all customers
• C. Rely solely on government monitoring
• D. Delay coverage for new applicants

Answer: (A)

Adverse selection happens when individuals know more about their own risk than the insurer, so high-risk people are more likely to buy coverage while low-risk people stay out. The best way to counter this is to break people into groups based on risk and price premiums accordingly. By grouping, the insurer can set different rates for different risk levels, aligning the cost with the underlying risk. This reduces the cross-subsidy that adverse selection creates and keeps the insurance pool balanced, making coverage attractive to both high- and low-risk individuals. Raising the premium for everyone doesn’t address the information gap and can discourage low-risk people from buying, potentially making the problem worse. Relying solely on government monitoring doesn’t directly solve the private-information issue that causes adverse selection. Delaying coverage for new applicants also fails to fix the asymmetry and can distort incentives.

Adverse selection happens when individuals know more about their own risk than the insurer, so high-risk people are more likely to buy coverage while low-risk people stay out. The best way to counter this is to break people into groups based on risk and price premiums accordingly. By grouping, the insurer can set different rates for different risk levels, aligning the cost with the underlying risk. This reduces the cross-subsidy that adverse selection creates and keeps the insurance pool balanced, making coverage attractive to both high- and low-risk individuals.

Raising the premium for everyone doesn’t address the information gap and can discourage low-risk people from buying, potentially making the problem worse. Relying solely on government monitoring doesn’t directly solve the private-information issue that causes adverse selection. Delaying coverage for new applicants also fails to fix the asymmetry and can distort incentives.