are a high-risk driver who has not yet had a major accident—but it is hard for the insurance company to collect

information about how people actually drive.

To understand how adverse selection can strangle an insurance market, recall the situation of 100 drivers who

are buying automobile insurance, where 60 drivers had very low damages of $100 each, 30 drivers had

medium-sized accidents that cost $1,000 each, and 10 of the drivers had large accidents that cost $15,000.

That would equal $186,000 in total payouts by the insurance company. Imagine that, while the insurance

company knows the overall size of the losses, it cannot identify the high-risk, medium-risk, and low-risk

drivers. However, the drivers themselves know their risk groups. Since there is asymmetric information

between the insurance company and the drivers, the insurance company would likely set the price of
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