Question

All MegaCorp employees who stay on the job for more than three years are rewarded with a 10 percent pay increase and coverage under a private health insurance plan that MegaCorp pays for. Tina just passed three years as a MegaCorp employee and reacts to having health insurance by taking up several dangerous sports because now she knows that the insurance plan will pay for any injuries that she may sustain. This change in Tina's behavior is known as: a. Defensive medicine. b. Asymmetric information. c. The moral hazard problem. d. The personal mandate.

Short answer

The change in Tina's behavior is known as the moral hazard problem (c).

Step-by-step solution

Understand the Scenario

In this problem, Tina has been employed for over three years at MegaCorp and, as a result, receives a reward of a 10% pay increase and private health insurance. The provision of health insurance leads Tina to indulge in risky activities.

Identify the Concept of Moral Hazard

Moral hazard is a situation where one party is more likely to take risks because they do not have to bear the full consequences, often due to having some form of insurance coverage. Tina’s behavior of engaging in dangerous sports knowing that her injuries will be covered by insurance is a classic example of moral hazard.

Compare with Other Options

- (a) Defensive medicine: This refers to practices by medical professionals to avoid litigation, such as ordering unnecessary tests. - (b) Asymmetric information: This occurs when one party has more or better information than the other in a transaction. - (c) Personal mandate: Often relates to legal requirements for individuals to have insurance coverage. Given these definitions, Tina's situation aligns most closely with moral hazard.

Verification

Consider the definitions provided in Step 3. Tina's behavior of embarking on dangerous sports is precisely what moral hazard describes—taking more risks because the negative outcomes are covered by insurance, not because of defensive medicine, asymmetric information, or a personal mandate.

Key concepts

Behavioral Economics

Behavioral economics examines how psychological factors and human behavior affect economic decisions. In the realm of risk and insurance, it helps us understand why individuals might act against their own best interests once they are covered by insurance. This is evident in the example where Tina changes her behavior after receiving health insurance. With the coverage, she feels shielded from the financial consequences of getting injured. Behavioral economics helps highlight the tendency of people to become lax in their risk-taking once they feel secure. For businesses, understanding human behavior patterns aids in structuring insurance plans that minimize reckless actions while keeping costs manageable. Incorporating insights from behavioral economics can lead

• to the adjustment of premiums based on behavior,
• the introduction of more personal health accountability measures, and
• providing incentives that encourage safe conduct.

Such strategies can help counteract behavioral tendencies towards moral hazard.

Insurance Economics

Insurance economics delves into how insurance markets function and the impact of these markets on both providers and consumers. Its principles are essential in understanding why insurance coverage can lead to moral hazard, as with Tina’s situation. When insured, individuals tend to take more risks, creating costs for insurers who will then need to assess such risks effectively. Insurance companies need to balance offering policies that are attractive but also viable. They achieve this by

• assessing risks with actuarial expertise,
• adjusting premiums to reflect potential payouts, and
• designing plans with deductibles and co-payments.

These mechanisms ensure that policyholders retain some responsibility for their actions, thereby discouraging reckless behavior. A solid understanding of insurance economics helps insurers design better products that meet customers' needs while ensuring profitability and sustainability.

Risk Management

Risk management is the process by which individuals or organizations identify, evaluate, and mitigate the potential negative effects of risks. In the case of insurance, it's about strategies to control both the likelihood of adverse events occurring and the significance of their consequences. Tina's case reflects a failure in personal risk management because she increases her exposure to danger without considering the potential outcomes. For insurers, effective risk management involves

• developing guidelines that encourage safe behavior among policyholders,
• using data analytics to predict and manage risk exposure,
• and employing educational programs that highlight the importance of maintaining lower risk levels even with coverage.

Through robust risk management practices, insurers can help reduce the moral hazard and encourage safer choices.

Incentive Structures

Incentive structures are powerful tools used to motivate behavior and decision-making. They can align individuals’ actions with desirable outcomes for both themselves and providers like insurance companies. In Tina's scenario, an improper incentive structure might inadvertently promote risk-taking behavior. Insurance companies often use incentives to encourage safer choices. Such incentives might include

• discounts for maintaining a no-claims bonus,
• rewards for attending safety workshops, and
• lower premiums for healthier lifestyles.

By structuring incentives carefully, companies can address the issue of moral hazard. Good incentive structures are tailored to steer behavior in a way that reduces risk exposure while ensuring that insurance remains attractive and accessible to the consumer.