Question

Anonymous . The Economist ; London Vol. 336, Iss. 7925, (Jul 29, 1995): 58.
ABSTRACT (ABSTRACT)
Insurance can reduce the devastating financial fallout from accidents, but it can also increase the risk of them
happening. To fend off moral hazard, some insurance firms tend not to offer full insurance coverage.
ABSTRACT
Although insurance can help to protect people from the financial impact of accidental misfortune, it may also
inadvertently make them more accident-prone.
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Economics focus: An insurer's worst nightmare
AEROPLANE crashes, oil spills and product failures are generally unpredictable events. But they are not totally
random: their occurrence can sometimes be influenced by human actions. And although insurance can help to
protect people from the financial impact of accidental misfortune, it may also inadvertently make them more
accident-prone.
Insurance works on the principle of pooling risks, and charging each customer a premium based only on the
average risk of the pool. This approach has much appeal: worldwide spending on insurance premiums continues
to rise. But it also presents two problems, which economists call "adverse selection" and "moral hazard".
Customers who have the greatest incentive to buy insurance are likely to be those who pose the worst risk for
insurers, hence adverse selection. A person will be keener to buy health insurance, for example, if he is already ill.
This increases the odds that insurers will have to pay claims and so may drive up premiums for healthier people. It
should not, however, increase society's total risk.
Moral hazard does. This describes the temptation for a customer, once he has bought insurance, to take greater
risks than he otherwise might have done. Moral hazard can take different forms. A customer might, for instance,
increase the chances that he will incur a loss; somebody with car insurance may drive more recklessly than he
would if he was uninsured. And even though an insured person may try to reduce the odds of a mishap, he may do
so in a way that increases the size of the potential loss. A firm that discovers it has a defective product, for
example, may withhold its findings to avoid early lawsuits it has to settle itself, while raising the risk of a huge later
payout that falls on its insurance company.
Insurers have long looked for ways to cope with these problems. To counter adverse selection, they may practise a
bit of their own: setting lower health-insurance rates for young people, for instance, or having their offices on the
fourth floor without a lift. And to fend off moral hazard, they tend not to offer full insurance, but to pass some risk
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back to customers. The best technique for this depends on the kind of moral hazard an insurer faces.
When confronted with moral hazard that increases risk, insurers often resort to a "deductible". This requires the
customer to pay in full the first portion of any claim. When someone crashes a car, for example, he often has to
pay the first few hundred dollars of expenses before collecting the rest from his insurer. This not only encourages
customers to drive more safely, but also cuts the insurer's administrative costs, since customers have no incentive
to file small claims.
To cope with moral hazard that might increase the size of potential losses, insurers demand "co-payments". Rather
than making customers pay the cost of a claim in full up to a certain limit, insurers require them to pay a fraction of
the entire cost. Since bigger losses will mean bigger co-payments for the insured, it will remain in customers'
interests to keep losses as low as possible.
Yet although insurers seem to have individual mechanisms that can cope with moral hazard, they run into trouble
when they try to combine them. Many insurers, for instance, ask customers to pay an initial deductible and a small
portion of all other costs above this. But this approach has a serious flaw, for deductibles can increase the moral
hazard that raises the size of potential losses.
Consider, for example, a car maker that discovers a possible defect in a batch of cars that it has sold. There is a
small chance that many of the cars have been built with a defective part, which would cause a string of fatal
accidents. For a cost of, say, $20m, the firm can recall all of these cars and repair them. If it does nothing, it risks
having to pay out several hundred million dollars if people are killed. The firm's insurer faces two kinds of moral
hazard: if it insures the company against all recalls, the firm may often use them for trivial reasons; if it insures it
only against large losses, the firm may avoid recalls altogether.
Mixing deductibles with small co-payments can make this worse. In some cases, the deductible will discourage a
recall by more than the co-payment encourages one, even if the right decision is to recall the cars. But combining
big deductibles with big co-payments might deter people from buying insurance altogether.

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Read carefully the document and then post your comments bearing in mind the following questions:

1 -

- Do you think insurers should be more concerned with adverse selection or moral hazard problem?

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2-

- How insurers can cope with adverse selection and moral hazard?

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3-

- Why insurers run into trouble when they try to combine "deductibles" and "co-payments"?

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please no hand writing

Answer 1

Answer 1:

Yes, the insurers  should be concerned about the moral hazard problem which reduces the incentives for people to be safe after they are being insured. Adverse selection is difficult to predict but the problem of moral hazard can be reduced by taking necessary steps.

Answer 2:

The problem of adverse selection can be controlled by setting lower health-insurance rates for young people, for instance, or having their offices on the fourth floor without a lift. The moral hazard problem can be controlled by co-payments and deductibles.

Answer 3:

Because discourage a recall by more than the co-payment encourages one, even if the right decision is to recall the cars. Mixing both will discourage people to buy the insurance altogether.