Suppose an insurance company has estimated that 20 percent of all of its potential policy owners are high- cost and sets a price for their insurance policy with the understanding that 20 percent of its policy owners will be high- cost. If the true percentage of high- cost potential policy owners is 40 percent, the insurance company is likely to face _______.

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Adverse selection occurs when one party has more information than the other party in a transaction, leading to a situation where the party with less information experiences an adverse outcome. In this scenario, the insurance company is setting a price assuming that 20 percent of potential policy owners are high-cost, but in reality, the true percentage is 40 percent. This means that the insurance company is underestimating the risk associated with insuring its policy owners, which is an example of adverse selection. The bad apple problem refers to situations where a few policy owners have a disproportionate impact on the insurance company's costs. Moral hazard refers to the situation where a party takes on more risk because they know that they will not bear the full costs of their actions. The principal-agent problem refers to situations where the incentives of an agent (e.g. an employee) are misaligned with those of the principal (e.g. the employer).

Suppose an Insurance Company Has Estimated That 20 Percent of All