Question

Explain in detail why and how moral hazard impacts the insurance system?

Answer 1

Moral hazard is a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost. It arises when both parties have incomplete information about each other. Moral hazard” refers to the additional health care that is purchased when persons become insured. Under the conventional theory, health economists regard these additional health care purchases as inefficient because they represent care that is worthless to consumers than it costs to produce. A new theory, however, suggests that much of moral hazard is actually efficient. When the care that was deemed to be welfare-decreasing is reclassified as welfare-increasing, health insurance becomes much more valuable to consumers than health economists have hitherto thought it was. As a result, there is a new argument for national health insurance: efficiency.

Description: In a financial market, there is a risk that the borrower might engage in activities that are undesirable from the lender's point of view because they make him less likely to pay back a loan. It occurs when the borrower knows that someone else will pay for the mistake he makes. This, in turn, gives him the incentive to act in a riskier way. This economic concept is known as moral hazard.
Example: You have not insured your house from any future damages. It implies that a loss will be completely borne by you at the time of a mishappening like fire or burglary. Hence you will show extra care and attentiveness. You will install high tech burglar alarms and hire watchmen to avoid any unforeseen event. But if your house is insured for its full value, then if anything happens you do not really lose anything. Therefore, you have less incentive to protect against any mishappening. In this case, the insurance firm bears the losses and the problem of moral hazard arises.

Moral Hazard and Health Insurance

Moral hazard is often misunderstood or misrepresented in the health insurance industry. Many argue that health insurance itself is a moral hazard since it reduces the risks of pursuing an unhealthy lifestyle or other risky behavior. This is only true if the costs to the customer, or the insurance premiums and deductibles, are the same for everyone. In a competitive market, however, insurance companies charge higher rates to riskier customers. Moral hazard is largely removed when prices are allowed to reflect real information. The decisions to smoke cigarettes or go skydiving look different when it means premiums can increase from $50 per month to $500 per month. Insurance underwriting is crucial for this very reason. Unfortunately, many regulations designed to promote fairness end up clouding this process. To compensate, insurance companies raise all rates.

Ensurers call the change in behavior that occurs when a person becomes insured “moral hazard.” Moral hazard occurs, for example, when an insured person spends an extra day in the hospital or purchases some procedure that he or she would not otherwise have purchased. Insurers originally viewed moral hazard unfavorably because it often meant that they paid out more in benefits than expected when setting premiums—hence the negative term. Economists also viewed moral hazard negatively because, under the conventional theory, the additional health care spending generated by insurance represents a welfare loss to society. ¹When people become insured, insurance pays for their care. In the economists’ view, insurance is reducing the price of care to zero. When the price is reduced in this way, consumers purchase more health care than they would have purchased at the normal market prices—this is the moral hazard. But because consumers purchase care when the price drops to zero that they would not have purchased at the market price, economists interpret this behavior as revealing that the value of this care to consumers is less than the market price. The additional care, however, is still costly to produce. The difference between the high cost of the resources devoted to producing this care (reflected in the high market price) and its low apparent value to insured consumers (reflected in the low insurance price) represents an inefficiency. Thus, health care spending increases with insurance, but the value of this care is less than its cost, generating an inefficiency that economists call the “moral-hazard welfare loss.”