How Do Insurance Companies Account for Moral Hazard? It can also take the shape of more pragmatic methods, such as higher deductibles and lower premiums in exchange for fewer claims. To build a fair system, however, given the scant knowledge insurers have about consumers who purchase their insurance, is a perpetual balancing act.
How can markets for insurance mitigate moral hazard?
There are several methods to reduce moral dangers. The first is to give incentives to the risk-taking party to urge them to act more responsibly. The second step is to implement regulations that prohibit immoral behavior by criminalizing it.
Assume, for instance, that there are two groups of individuals in the population: those who smoke and do not exercise, and those who do not smoke and do exercise. Those who smoke and choose not to exercise have shorter life expectancies than those who do not smoke and prefer to exercise.
Consider two persons seeking life insurance: one who smokes and does not exercise, and the other who does not smoke and exercises every day. Without further information, the insurance provider cannot discern between the individual who smokes and does not exercise and the other individual. The insurance firm requests that individuals complete out identification forms.
However, the individual who smokes and does not exercise understands that if they answer honestly, their insurance costs would increase. This person decides to lie and state that they do not smoke and workout regularly. This results in adverse selection; the life insurance company will charge both persons the same premium.
However, non-exercising smokers benefit more from insurance than exercising non-smokers. The smoker who does not exercise will require more health insurance and will profit from the cheaper rate. Insurance firms restrict their risk to high claims by increasing rates or limiting coverage. Insurance firms seek to limit the possibility of adverse selection by identifying and charging higher premiums to groups of individuals who pose a greater risk than the general population.
Underwriters of life insurance evaluate applicants for life insurance to determine whether or not to provide coverage and how much to charge in premiums. Typically, underwriters analyze every factor that may affect an applicant’s health, including as height, weight, medical history, family history, work, hobbies, driving record, and smoking habits.
What strategies might diminish moral risks?
The essence of moral hazard is risk-taking. Moral hazard often develops when one party or individual in a transaction takes risks with the knowledge that, if things go wrong, another party or people would bear the negative repercussions. The detriment to the second party might arise during the transaction, prior to the transaction, and even after the transaction has occurred.
There are several methods for reducing moral hazard, including incentives, regulations to restrict immoral activity, and routine monitoring. Unbalanced or unequal information is the primary cause of moral hazard. The party assuming the risks in a transaction has greater knowledge of the circumstances or intentions than the party bearing the repercussions.
Generally, the party with more knowledge has greater motive or is more inclined to conduct unethically in order to gain an advantage in a transaction. Frequently, the benefit of asymmetric information is realized after the transaction has been completed.
What is moral hazard in relation to insurance?
Key Takeaways – Moral hazard refers to the behavioral changes that may occur and raise the risk of loss when an individual is aware that insurance coverage is available. When an individual is able to avoid the possible consequences of a risk, their actions and attitudes alter, and the chance of moral hazard increases.