Question

Discuss how selection and moral hazard impact the demand for insurance (Who and how many people buy).

Answer 1

Moral Hazard occurs when the insured person takes more risks because of protection against the risks from his insurance coverage. For eg: A person with a house insurance will be more careless about his house security because he knows any loss will be borne by the insurer. So a careless person will always expose himself to more risks depending on the insurance coverage.

Adverse selection occurs when asymmetric information is exploited. It happens when one party has more information than the other party about a transaction. In case of Life Insurance, it is the buyer who has more knowledge(about his health) than the seller. Due to this, the insurance companies charge high premiums from people more at risk or reduce their exposure to large claims to reduce their loss. The buyers at higher risk will have to pay more money to buy an insurance. For eg. A smoker need to pay higher premium than a non-smoker for a life insurace.