Question

Briefly discuss the similarities and differences between Adverse Selection and Moral Hazard.

Answer 1

Adverse Selection:

• Adverse selection is an undesired result because one party has more information or a product advantage (client/prospect) than the other party anticipates (insurance company).
• The client/prospects seizes the opportunity because of the imbalance in information that they possess or the product advantage which weighs in their favor.
• Adverse selection is condition that exists prior to a policy being put in force.

Moral Hazard:

• A moral hazard exists when a person (or entity) intentionally takes additional risk or exaggerates a loss because someone else (insurance company) is going to bear the costs of those risks.
• A moral hazard generally exists after a policy is put in force.

One of the most prominent examples of adverse selection can be found in the market for used cars (i.e., the market for lemons). In this market, the sellers have more knowledge about the quality and the history of their cars than the buyers. For the sake of the example, we’ll assume there are two types of cars in this market, high-quality cars (peaches) and low-quality cars (lemons). The sellers know whether a car is a lemon or not, but the buyers cannot distinguish between the two (since lemons can only be identified as such after they have been bought).

An excellent example of moral hazard can be found in the market for car insurance. In this market, the buyers can avoid a large share of the negative consequences of their actions once they have insurance for their cars. Many of them will be extra careful with their trucks before getting insurance because they have to pay for damages and repairs themselves. However, once they get insurance, some drivers feel like they don’t have to be as careful anymore because insurance will cover the costs if anything happens to their car. This can lead to more reckless driving or just an overall increase in carelessness on the road. Of course, this kind of behavior is not desired and puts the insurance companies at a disadvantage.