Q2 Auto insurance: In 1992 in New Jersey, auto insurance premiums were extremely high and drivers facing very high premiums decided not to buy any insurance at all. The governor of New Jersey decided to remedy the situation by offering a state sponsored auto insurance policy that would be available to all drivers. Insurance premiums were calculated based on average driver risk in the state during the previous three years. (Based on an exam question.)

What factors might have caused New Jersey's auto insurance fund to experience a large deficit?

Choice 1:Moral hazard

Choice 2:Adverse selection

Choice 3:Both moral hazard and adverse selection

Explain how these factors would lead to an insurance fund deficit.