A small town has 1,000 people, 600 of whom are healthy and 400 of whom are sick. The annual expected medical claims of the healthy and sick are $500 and $9,000, respectively. If the insurance company cannot determine who is healthy and who is sick prior to the purchase of insurance, adverse selection ___ likely to happen because ____.

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Adverse selection is likely to happen because sick people, who have higher expected medical claims, are more likely to buy insurance, while healthy people, with lower expected medical claims, are more likely to forgo it. This creates an imbalance in the insurance pool, skewing it towards higher-risk individuals.

A Small Town Has 1,000 People, 600 of Whom Are