Question

How can moral hazard lead to more costly insurance premiums than one was expected?

Short answer

Moral hazard can lead to more costly insurance premiums than initially expected because it increases the insured's risk profile due to their riskier behavior after obtaining coverage. This forces the insurance company to adjust its premiums to cover the higher number of claims and increased risk level, resulting in higher premiums for all policyholders.

Step-by-step solution

Understand moral hazard

In the context of insurance, a moral hazard occurs when the insured individual is more likely to engage in risky behavior or to be less careful after obtaining insurance coverage. This occurs because the insured person bears less financial risk due to the protection provided by their insurance policy.

The connection between moral hazard and insurance premiums

Insurance premiums are calculated based on the level of risk associated with the person seeking the coverage. If an individual exhibits behavior that suggests they are more likely to incur a loss, the insurance company will view them as a higher risk and charge a higher premium to compensate for the increased likelihood of having to pay out a claim.

How moral hazard leads to higher premiums

If an insured individual engages in behavior that increases their risk after obtaining coverage, the insurance company may not have accurate information to establish a fair and accurate premium. As the insured person's risk profile changes due to their increased risky behavior, the insurance company may have to pay out more claims than initially expected, leading to an imbalance between the premium collected and the payouts made. To maintain financial stability, the insurance company will have to adjust its premiums to cover the higher number of claims and to account for the increased risk level. This can lead to higher insurance premiums than initially expected, as the insurance company adjusts to account for the moral hazard.

Conclusion

Moral hazard can lead to more costly insurance premiums than initially expected because it involves the insured engaging in riskier behavior after obtaining coverage, thus raising their risk profile. The insurance company must adjust its premiums to compensate for the higher risk and increased frequency of claims, which can result in higher premiums for all policyholders.