Question

Prompt: Insurance companies charge premiums for each type of insurance policy they issue. Underwriters assess risk for specific types of policies. Premiums are calculated and then charged to the insured. Discuss the adverse selection and moral hazard problems insurance companies face.

Requirements: 250 words

Answer 1

Answer: Moral hazard and adverse selection is the term which is usually considered in insurance. Moral hazard occurs when one of the party to contract provides misleading information because of their opinion that the actions won't have any consequences. It is basically a risk that one of the party to the contract has not entered the contract in a good faith and therefore it is possible that misinformation may have been provided by the party with respect to their assets, liabilities or credit capacity etc. For example, in a contract of insurance, a homeowner becomes less vigilant, once he has taken insurance for flood or burglary etc. this creates moral hazard for the insurance company as they may have to incur losses due to less attentiveness of the homeowner.

It is a situation in which one of the party under the contract has more accurate information than the other party, for example a chain smoker and non exercising individual may hide this information from the insurance company, in order to get a low premium for the insurance, this can lead to adverse selection from the side of insurance company. The party with less information is at disadvantage under the contract.