What is one approach to mitigate the effects of adverse selection?

Charging higher premiums to higher-risk individuals is a key approach to mitigating the effects of adverse selection. Adverse selection occurs when there is an imbalance in information between buyers and sellers of insurance, typically resulting in those who are at a higher risk being more likely to purchase insurance. By increasing premiums for individuals deemed to pose a higher risk, insurers can better align the cost of coverage with the potential liabilities they face. This practice discourages high-risk individuals from disproportionately entering the insurance pool and helps maintain a more balanced risk distribution among policyholders.

Higher premiums for high-risk individuals not only generate necessary revenue for the insurer to cover potential claims but also encourages those individuals to reconsider their choice of coverage or, in some cases, seek alternative solutions, thus reinforcing the sustainability of the insurance pool.

The other options do not effectively address the problem of adverse selection. Offering discounts to all policyholders, for instance, could lead to lower overall premiums that do not reflect the actual risk levels, thereby potentially attracting more high-risk individuals. Reducing coverage limits for all policies may reduce potential payouts but does not directly influence risk selection. Finally, eliminating underwriting processes would remove the assessment of risk entirely, further exacerbating adverse selection by allowing anyone, regardless of risk level, to obtain insurance