Question

What is the effect of the moral hazard problem on insurance premiums? Explain your answer.

Answer 1

Assymetric information leads to the problem of market failure because of adverse selction and moral hazard problem in these markets. The problem of moral hazard is a hidden action problem which mainly occurs after the person has been insured in the insurance market. It refers to the problem where one party gets involved in a risky event because it is protected against the risk and does not has to bear the full cost of the risk. To minimize the problem of moral hazard, insurance companies use co-insurance schemes where the person who is insured also has to bear the equal amoount of loss borne by the insurance company.

Due to the problem of moral hazard, it has been observed that companies have increased their insurance premiums in the insurance market. This is because when insurance becomes costly, then the person also takes care the actions taken by him/her which will help in reduction of loss and this in turn reduces the problem of moral hazard or hidden action which companies have to face because this makes the person more accountable to his/her actions.