Question

An insurance company is considering issuing three types of fire insurance policies: (i) complete insurance coverage,(ii) complete coverage above and beyond a $10,000 deductible,

and (iii) 90 percent coverage of all losses. Which policy is more likely to create moral hazard problems?

Short answer

The problem of moral hazards will occur mostly in the case of the complete coverage rather than in the case of policies with $10,000 deductibles and 90 percent coverage of loss.

Step-by-step solution

Meaning of moral hazard

The problem of moral hazard occurs when one of the parties begins to act against the agreement after entering into an agreement. Such a hazard primarily occurs in an insurance market where the insured starts to take things less seriously as they are covered by insurance.

The policy of complete coverage will create a moral hazard

Out of all the three policies, the policy of complete coverage is most likely to create a problem of moral hazards.When a person has the assurance that the insurance policy will financially cover any damage, they start to act ignorantly.For example, if a shopkeeper gets fire insurance, he will be less likely to always switch the power before closing the shop since he will get assured that he will get the loss to be by fire covered.

However, in the case of $10,000 deductibles and a 90% coverage policy, customers are less likely to become ignorant since they have some money to lose here. The issue of moral hazard may not arise here.