Question

Do you think we live in a more moral hazard society versus adverse selection?

Answer 1

Moral hazard and adverse selection are the terms mainly used in economics, insurance sector and risk management. These terms describes the situation wherein one of the two parties is at disadvantage.

Moral hazard is a situation where both the parties have same information before the deal but one of the parties behaviour changes after the deal is struck. For example, if a homeowner who lives in flood prone area always protects his home by preparing for the floods and prevents the damage. But at some point of time he is tired of doing this always and so he buys home insurance. But after buying insurance, his behaviour changes and he stops preparing for floods and the insurance company has to bear the risk. Here, the moral hazard rises.

Adverse selection is a situation wherein one of the parties of the deal has more accurate information and that which is different from the information the other party has. Here, the party which has less information is at loss or disadvantage. For example, there are two men, one who smokes and does not exercise and one who does not smoke and does exercises. Both of them buys life insurance. When asked to fill the questionnaire by the insurance company, the one who smokes and does not exercise knows that if he fills in the correct information, he would have to pay more premium than the one who does not smoke and does exercise. So, he lies and fills the information that he does not smoke and also does exercise. Here, the insurance company cannot find the truth and thus it is at a disadvantage and charges the same premium amount from both individuals. This is adverse selection for the insurance company.

Thus, we live in a more moral hazard society versus adverse selection. Both are prevalent in our society.