Question

4. For each of the following kinds of insurance, explain briefly what sort of behavior might be encouraged by moral hazard:

a. insurance against a home being damaged by flooding;

b. insurance against having the paint on your car badly scratched;

c. insurance against being fired from one’s job;

d. insurance for a business against the risk of suffering losses rather than earning profits.

Answer 1

Answers:

(a) The flood insurance will increase moral hazard because home-owners may decide to build or buy houses in flood prone area, most home insurance contracts protect against water damage caused by moment of distraction.

(b) The car-paint insurance may result in more reckless driving because car owners need not drive too carefully to avoid scratches, aware that the insure will pay for the scratch caused by the their risky driving.

(c) This insurance will not be likely to change the worker's behavior. This is because, if he becomes more inefficient and loses his job, the job-loss policy triggers only if the termination is due to the conditions of your portfolio, your investment is the best insurance against a job loss it.

(d) This will encourage the business owners to take more risky decisions like investing in unworthy projects, expecting returns but aware that if such investment results in losses, finally it will be definite whether or not a loss has occurred,