Question

In: Economics

Before purchasing insurance, you behaved carefully against the flu. Based on your previous behavior, the insurance...

Before purchasing insurance, you behaved carefully against the flu. Based on your previous behavior, the insurance company calculated actuarially fair insurance($100), sold the insurance to you, and was willing to cover your expected financial lose. After purchasing the insurance, you became careless. In turn, the insurance company cannot know (they could guess but can’t verify) your changed behavior against the flu (this is called the problem of “asymmetric information”). Thus, the insurance company have no choice but to cover your increased expected financial lose.

Question 1. Suppose your copayment rate is 30% and the insurance company copayment rate is 70%. How much do you assume the cost of moral hazard? Also, how much does the insurance company assume the cost of moral hazard? Show how you calculate both costs of moral hazard. Under this insurance, do you have an incentive to be more careful against the flu?

Solutions

Expert Solution

I will answer question one by one.

The purpose of insurance is to have protection against uncertain losses in the future. The cost of protection is the premium which a policyholder pays to the Insurance company and it can be either a lump sum or in installments. Some of the policies have copay in them to ensure that part of the loss is to be borne by the policyholder. Copay reduces the premium. Whereas moral hazard is a negative tendency of the policyholder to act carelessly or increase his/her exposure to risk when insurance company bears the cost of the risks.

Part 1 - Suppose your copayment rate is 30% and the insurance company copayment rate is 70%. How much do you assume the cost of moral hazard?

Cost of moral hazard depends on the company to the company of insurance. But generally, insurance company take the following steps in case of moral hazard -

  • Increase in the amount of premium/cost of insurance.
  • Change the terms of insurance policy.
  • Increase the Co-pay amount.
  • Reduction in claims payment at time of loss
  • Revocation/cancellation of policy in case of fraudulent moral hazard.

Part 2 - Also, how much does the insurance company assume the cost of moral hazard? Show how you calculate both costs of moral hazard

Cost of moral hazard depends on company to company and on the seriousness of the moral hazard. Moreover, it depends on the terms and condition of the policy. (refer to answer of the previous part).

In the question the policy mandates to take precautions against the flu, however, the policyholder acts recklessly as someone else bears to cost of risk. On claim, policyholder reduces the claim amount or increase the copay or increase the premium if the policy exists

Part 3 - Under this insurance, do you have an incentive to be more careful against the flu?

Yes, again it depends on the type of policy one takes and from which insurance company. Being careful is beneficial both for insured and insurer as insured will be healthy and insurer have to pay fewer claims hence incurring more profit.


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