why is disclosure important when taking out insurance?

Question

anonymous · Answer

Because of self-selection: the people who want insurance most, are the ones who are costly for the insurer. 
In an example: 

An individual who loses their car, has to buy a new one. If we pool all resources of a large group of people, we can buy the car immediately, if everyone contributes a small amount: the insurance premium.

The probability that a car will get stolen is quite small, therefore, the insurance company needs to charge only a premium equal to the value of the car times the probability. Usually people don't mind paying it, as it insures them they will have a car next month still. 

However, the people who need the insurance the most are the ones whose car has just been stolen. If the insurance does not require disclosure, people would wait until their car has been stolen before taking out the insurance.