Question

Customer acquisition cost (CAC) of a new driver is between $400 - $600. CAC is sensitive to the rate of acquisition since channels are only so deep.

Answer 1

Adverse selection, stemming from asymmetric information, poses a significant challenge for insurers as it can lead to financial losses. In a case with 100 drivers, when the insurer can't differentiate by risk level and sets uniform premiums, only high-risk drivers are inclined to buy insurance, leading to greater claims than premiums collected.

Step-by-step explanation:

The concept of adverse selection is a significant challenge in the insurance market due to asymmetric information between the insurer and the insured. In a scenario with 100 drivers and varying levels of risk and accident costs, the average damages amount to $186,000.

If the insurance company is unable to distinguish between low-risk, medium-risk, and high-risk drivers, they might set a flat insurance premium at $1,860. However, those with low and medium risks will likely opt out, leaving the insurer selling policies mostly to high-risk individuals who have claims averaging $15,000.

This disparity leads the insurer to suffer financial losses, and raising premiums would further deter low and medium risk drivers from purchasing insurance, exacerbating the issue of adverse selection.

If an insurance company cannot accurately assess the risks and set premiums accordingly, it may end up losing money as only high-risk drivers would find it financially sensible to buy the insurance. This situation elucidates the challenges an insurer faces without sufficient data to correctly price the risk of clients, which is essential in avoiding adverse selection and maintaining financial viability.

Answer 2

Adverse selection in insurance markets refers to a scenario where asymmetric information leads to a mismatch of insurance premiums and risk levels, as insurers cannot identify different risk groups among consumers, which may cause a market imbalance and financial losses for the insurer.

Step-by-step explanation:

Understanding Adverse Selection in Insurance Markets

Adverse selection occurs when there is asymmetric information between two parties, such as insurance companies and policyholders. In the case of automobile insurance, if insurers cannot identify high-risk, medium-risk, and low-risk drivers, they may set a uniform price based on average losses. Considering a scenario with 100 drivers and varying accident costs resulting in a total of $186,000 in payouts for the insurance company, a uniform price would discourage low and medium risk drivers from purchasing insurance. The remaining high-risk drivers cause the company to incur greater payouts, resulting in losses, especially if premiums are raised to offset these high claims. This imbalance due to asymmetric information can strangle an insurance market as it leads to a poor match between insurance premiums and the risk levels of drivers.