The Concept of Moral Hazard - Essay Example

MORAL HAZARD-A DISCUSSION Moral Hazard-A Discussion Introduction According to Spencer (2000) , that there are two major types of asymmetric information that can be seen in financial markets, called endogenous1 asymmetric information and exogenous2 asymmetric information. The two major problems arising from exogenous asymmetric information are moral hazard and adverse selection. In this essay, the concept of moral hazard, its effects on insurance markets and its various solutions are discussed. Moreover, it is compared and contrasted with adverse selection and its effects on insurance markets. 2. Moral Hazard and Adverse Selection Moral hazard occurs due to asymmetric exogenous information between the insurer and the insured people. The insurer will not know whether the insured one cannot monitor the actions taken by the insured ones and at the same time, two markets will be contracted at fair premiums. Consequently, everyone will most probably buy the cheaper premium and claim that they are taking care. This is called moral hazard problem (Katz and Rozen, 1998). Adverse selection also occurs due to the asymmetric exogenous information between the insurer and the insured people. Here the insured knows more about the type of risk better than the insurer at the time of contracting (Katz and Rosen, 1998). Thus, while insured knows more than the insurer about the behaviour of risk in the case of moral hazard, the insured knows more than the insurer about the type of risk in the case of adverse selection. Both however arise due to asymmetric information. Moral hazard takes place after a transaction has taken place while adverse selection tends to occur before any transaction takes place (Rees, 1989).Hence moral hazard changes incentives and behaviour on the demand side while adverse selection prevents any deals taking place(Rees,1989). 3. Effects on Insurance Markets In the case of moral hazard, each insurer will try to get cheaper premium and an outcome without having any expenditure on care. This results in a higher probability of loss after the contract than the time of initiation of the contract. This will result in a loss to the insurer and such contracts will not represent a competitive equilibrium (Hiller, 1997). For example, in liability insurance due to moral hazard it is possible that insured one takes sufficient care not to harm others and is sued by them for damages. Here the insurers cannot monitor the insured and this results in a loss to the insurer. In fire insurance, also it is possible that the insured one will not take adequate care to prevent the fire and can claim the same costs. In the case of medical insurance, it is possible that the insured person visits the doctor for minor injuries or illnesses often and claims the insured amount. In property insurance there is possibility of exaggerating the loss by the insured one after break in .In all these cases, the insured one will not take adequate care and at the same time select the cheap premium. The insurer cannot monitor the insured in all these cases and will result in a loss to the insurer due to asymmetric information (Rees, 1989). In the case of adverse selection, it may prevent any deals taking place. It helps to explain why financial market is not ‘complete’ - many risks are uninsurable. What happens is that the high quality suppliers realise that they are getting a bad deal and leave the market. They may be forced to leave the market if they are high cost producers. In this case the average quality and hence the pool price falls, it probably causing medium quality suppliers to leave with a downward spiral in quality and price (Biswas, 1997). Adverse selection problems are sometimes called hidden information problems (Hiller, 1997). For example, in the health insurance market, there is possibility that less health people choose managed care and less healthy people choose more generous plans (David and Zeckhauser, 1997). Hence, due to asymmetric information, the insurers will get a bad deal and they are forced to leave the market. In the case of life insurance ,for example, smokers may by the insurance more likely than non smokers. Consequently, the average mortality of the combined policyholder group will be higher than the average mortality of the general population. This will result in a deterioration of the quality of the insurance. Hence, the insurers are more likely to increase the price and the non-smokers will have a lesser chance to by at this higher price (Polborn et al, 2006).In all these cases, the insurer will not be able to monitor the insured ones and have asymmetric information. 4. Moral Hazard, Policy Conditions and Design of Contracts In many studies, two partial solutions have been discussed for moral hazard (Gropp and Vesala, 2004). They are incomplete coverage against loss and the observation by the insurer of the care taken to prevent the loss (Shavell, 1979). In the first case, the insured is exposed to some financial risk. This gives an incentive to the person to take adequate care to protect him/her from the loss. In the second case, the insured one will be motivated to prevent loss since due to the monitoring the insurer can link the perceived care in two alternative ways .One is through the insurance premium or through the amount of coverage paid in the event of a claim (Shavell, 1979). In the first case, it is possible that the insurer can expect the worst case assuming that the insured one takes no care. The premium will be then designed to reflect this. Consequently, there will be no incentive for anyone to take care. In this case, means everyone is paying high premium for a contract giving full cover .However, this could have been made cheaper with only a small expenditure on care (Shavell, 1979). Hence, a solution to this is to choose a level of cover for which the insurer has adequate incentive to take care and hence reducing the fair premium called contract design (Rees, 1989). If this can increase the expected utility than the complete coverage, then this combination will be more attractive to everyone resulting in a partial marketing equilibrium (figure 1). In the following figure, ‘ b’ is the initial equilibrium at full cover, e and e’ are the partial cover contracts at a low premium depending on the care taken. This optimal partial insurance however varies with different decisions on care and different levels of cover. Figure 1: Optimal Partial Insurance Outcome In the second case of observation by the insurer, the solution to moral hazard depends on the accuracy of the observations of the insurer and the timing of observations. In the case of completely accurate observations by the insurer, full coverage can be considered as desirable as argued in many studies irrespective of the timing of observations whether they are made at the time of policy purchase or at the time of presenting a claim. In case of inaccurate observations, however, an additional risk is imposed on the insured persons .This is because there will be many random factors influencing the observations of the insurers which will be reflected in the premium. In such cases, this risk factor can create an incentive for the insured one to take adequate care to prevent loss if the information about the changes in the level of care is reflected in the observations .Policy can be designed to create the optimal outcome in this case(Shavell,1979;Harris and Raviv,1992). 5. Conclusion In this essay, the differences between moral hazard and adverse section and their effects on insurance markets are discussed. The discussion also shows that there can be different solutions to moral hazard depending on different levels of care taken and different levels of cover. These include partial coverage and observation by insurer. In these two cases, the policy needs to be designed in such a way that the premium or the level of cover will be optimal when compared to the original premium References Biswas T(1997):“Decision-Making under Uncertainty”, London: MacMillan. David M. C and R J. Zeckhauser(1997): "Adverse Selection in Health Insurance," NBER Working Papers 6107. Gropp R and J Vesala(2004): “Deposit Insurance, Moral Hazard and Market Monitoring”, European Central Bank Working Paper Series No.302. Harris M, and A. Raviv(1992): "Financial contracting theory", in: J.J. Laffont (Ed.), Advances in economic theory: sixth world congress, vol. 2, Cambridge. Hiller B (1997): “The economics of asymmetric information”, New York: St Martin’s Press. Katz M and Rosen H(1998): “Microeconomics” 3rd edn, Chicago:Irwin. Polborn M K , M Hoy and A Sadanand(2006): “Advantageous Effects of Regulatory Adverse Selection in the Life Insurance Market”, The Economic Journal, Volume 116,Issue 508,P327-354. Rees R (1989) "Uncertainty, Information and Insurance" in Current Issues in Microeconomics J D Hey ed, London: MacMillan. Shavell S (1979) : “On Moral Hazard and Insurance”, Quarterly Journal of Economics 93,pp. 541-562. Spencer P D(2000): “The Structure and Regulation of Financial Markets”, Oxford: Oxford University Press. . Read More