Question

Say whether each of the following scenarios describes an insurance problem caused by adverse selection or by moral hazard. [LO 11. 7] a. People who have homeowners insurance are less likely than others to replace the batteries in their smoke detectors. b. People who enjoy dangerous hobbies are more likely than others to buy life insurance. c. People whose parents died young are more likely than others to enroll in health insurance. d. People who have liability coverage on their car insurance take less care than others to avoid accidents.

Short answer

a: Moral hazard, b: Adverse selection, c: Adverse selection, d: Moral hazard.

Step-by-step solution

Understanding Adverse Selection and Moral Hazard

Adverse selection occurs when individuals with higher-than-average risk are more likely to purchase insurance. Moral hazard refers to the tendency of insurance coverage to change the behavior of the insured in a way that increases risk. Knowing these definitions will help determine the classification of each scenario.

Scenario Analysis: Smoke Detectors

a. People who have homeowners insurance are less likely than others to replace the batteries in their smoke detectors. This scenario describes moral hazard, as those with insurance feel less incentive to reduce risk by maintaining their smoke detectors.

Scenario Analysis: Dangerous Hobbies

b. People who enjoy dangerous hobbies are more likely than others to buy life insurance. This scenario depicts adverse selection. Here, people with higher risk due to their hobbies are more inclined to seek life insurance coverage.

Scenario Analysis: Family Health History

c. People whose parents died young are more likely than others to enroll in health insurance. This describes adverse selection because individuals with a family history of early death (higher perceived risk) are more likely to get health insurance.

Scenario Analysis: Car Insurance and Behavior

d. People who have liability coverage on their car insurance take less care than others to avoid accidents. This illustrates moral hazard, as having insurance coverage leads to riskier behavior on the road.

Key concepts

Insurance Problems

Insurance problems arise when there is a mismatch between the insured individuals' risk levels and the insurance companies' ability to manage those risks. Such problems affect the efficiency and effectiveness of insurance markets. These issues often materialize in two primary forms: moral hazard and adverse selection.

• Moral hazard describes situations where insured individuals may alter their behavior because they are protected from the consequences. For instance, if someone has comprehensive insurance coverage, they might take less precautionary measures, knowing they're covered if something goes wrong.
• In adverse selection, the individuals seeking insurance often possess insights about their risk levels that insurers might not know. These individuals are typically higher-risk and more motivated to buy insurance, thus leading to a risk pool that's skewed towards high-risk insureds.

Understanding these scenarios helps insurers design better policies that correctly price the risk and encourage safer behavior among the insured.

Risk Behavior

Risk behavior is the way individuals or entities act when confronted with potential dangers or losses. In the context of insurance, risk behavior becomes a crucial factor that insurers need to evaluate and potentially control through effective policy design.

• Individuals with insurance might engage in riskier behaviors because they feel shielded from the financial ramifications of their actions. This is the essence of moral hazard and explains why, for example, a person with car insurance might drive less cautiously.
• The insurance market aims to create incentives that encourage risk-averse behavior. Policies often include deductibles or co-payments to ensure that the insured maintain a vested interest in minimizing risks.

Risk behavior plays out in various ways, influencing how individuals prioritize safety and make decisions, especially when they perceive their risks to be covered by insurance.

Adverse Selection

Adverse selection refers to a situation within insurance markets where those who are most likely to file a claim are the ones who seek insurance cover. This can create significant challenges for insurers.

• It occurs because individuals possess private information about their own risk levels that they might not disclose to insurers. For example, someone aware of high health risks may be more inclined to purchase health insurance.
• Adverse selection can lead to a disproportion of high-risk policyholders, which might cause insurers to raise premiums, discourage low-risk individuals from enrolling, and possibly destabilize the insurance market.

Insurers fight adverse selection through various methods, such as comprehensive underwriting processes or incentivizing safer behavior through lower premium rates for those less likely to make claims.