Question

The state of California set up its own earthquake insurance program for homeowners in 1997. The rates vary by ZIP code, depending on the proximity of the nearest fault line. However, critics claim that the people who set the rates ignored soil type. Some houses rest on bedrock; others sit on unstable soil. What are the implications of such rate setting?
A. This rate setting scheme creates a moral hazard problem: Homeowners with houses on unstable soil are less likely to purchase insurance because the rate is much higher for them.
B. This rate setting scheme creates a moral hazard problem: Homeowners with houses on unstable soil are more likely to purchase insurance than homeowners
C. This rate setting scheme creates an adverse selection problem: Homeowners with houses on unstable soil are less likely to purchase insurance because the rate is much higher than for them.
D. This rate setting scheme creates an adverse selection problem: Homeowners with houses on unstable soil are more likely to purchase insurance than much higher for them. with houses that rest on bedrock. rate is much higher for them homeowners with houses that rest on bedrock.

Answer 1

Answer: This rate setting scheme creates an adverse selection​ problem: Homeowners with houses on unstable soil are more likely to purchase insurance than homeowners with houses that rest on bedrock

Explanation:

California has its own earthquake insurance program for homeowners and the rates vary by the ZIP code, which depends on the proximity of nearest fault line.

However, critics claim that the people who set the rates ignored soil type. Some houses rest on bedrock while others sit on unstable soil. If the soil type is used, rate setting scheme creates an adverse selection problem.

An adverse selection problem is tendency of those in high-risk areas to purchase the insurance claim because there are higher chances they may get affected. Therefore, the homeowners with houses on unstable soil will more like buy insurance than the homeowners with houses that rest on bedrock.