Introduction and Theory
Beyond Risk Spreading
Moral Hazard
Typically used to refer to the theoretical tendency for insurance to reduce incentives to:
Protect against loss,
Example – Leaving a car door unlocked, comfortable in the knowledge that if the car is stolen, the insurance company will pay to replace it
OR Minimize the cost of loss
Example – Not caring very much about what it costs to repair a car as long as the insurance company pays for it
Economists refer to moral hazard as an information problem because insurance companies could eliminate moral hazard if they could determine what people would do to be careful in the absence of insurance and then require people to take the same level of care with insurance
Economists refer to this effect to counteract moral hazard as “contracting on care.” Insurers cannot completely contract on care, however, because they don’t have a cost-free way to get the necessary information. Even if they could determine the appropriate level of care, they could not, as a practical matter, monitor people to determine whether they were taking that level of care
Overall, there are three strategies to address moral hazard:
Contract on care
provide a financial incentive for the PH to invest some form of durable protection (a car alarm, a dead bolt lock, or sprinkler system)
Community of fate
Create a community of fate with the PH, so that the PH feels some of the pain of the loss. A deductible (PH pays the first X$ of any los) is the most common example. (in health care – co-payments)
Designing insurance contracts so that risks that pose a very high degree of moral hazard are not covered or are covered less completely
In general, the greater the control the insured has over the loss, the greater the moral hazard and the less complete protection an insurance company will be willing to provide. This helps explain why insurance companies generally are reluctant to insure against intentional harm and why health insurance companies are unwilling to insure against cosmetic surgery
Moral hazard is more often applied to the PH side; but the IC’s are subject to moral hazard as well.
Economists have generalized the concept of moral hazard, demonstrating that it applies not only to people buying insurance, but also to all principle-agent relationships
Any time an agent acts on behalf of a principle, the agent has an incentive to carry out the action in a way that benefits the agent. This does not mean that agents necessarily betray their principles, but they ha
insurance law and regulation are devoted to making sure that insurance companies live up to their promises.
Regulation ensures that companies are capable of fulfilling their promises
Positive externalities
Benefits to people who are not parties to insurance contract.
Almost all forms of insurance make people feel more secure, which provides very substantial benefits to people they live or work with or who otherwise depend on them
Main functions of insurance
Harm prevention
Once insurance institution assumes responsibility for the financial consequences of the harm, it has a substantial incentive to prevent that harm.
Gate keeping
Obtaining insurance is often a prerequisite to other activity
You can’t register a car without auto insurance, can’t take out a mortgage without homeowner’s insurance, etc.
