Moral Hazard and Adverse Selection

Insurance allows you to deal with risk through pooling. If one out of 1000 homes will burn each year, each person can contributes to a general fund 1/1000 of the value of his home. The fund will have enough (ignoring administrative expenses) to reimburse those whose homes burn down.

People are willing to pay a contribution to avoid risk. They get nothing if there is no loss. If misfortune strikes, the insurance pay back the value lost in the misfortune.

By changing the costs of misfortune, insurance can change people's behavior. They will make less effort to avoid misfortune. This change in behavior is called moral hazard.

Here are some possible impact of moral hazard: fire insurance encourages arson, automobile insurance encourages accidents, disability insurance encourages dismemberment.

Private insurance tries to keep the insured value of any misfortune less than the value to the insured person. It tries to keep buildings and automobiles insured for less than their true worth. In addition, it is usually against the law to create the misfortune that you are insured against.

If the problem of moral hazard is too great, there will be no insurance coverage for the misfortune.

The insurance industry can also face the problem of adverse selection. People who buy insurance often have a better idea of the risks they face than do the sellers of insurance.

Insurance companies try to minimize the problem of adverse selection. They measure the risk and adjust the prices to match this risk.

Life insurance companies require medical examinations. They will refuse policies to people who have terminal illnesses. Automobile insurance companies charge much more to people with a conviction for drunk driving.