The Concept of “Adverse Selection” and “Moral Hazard”

Subject: Case Studies
Pages: 3
Words: 561
Reading time:
2 min

Adverse selection refers to the insurance policies that attract customers who most need the insurance and who think that they will obtain extra benefits out of the insurance than what they paid in the premiums and the deductibles. It is a problem of screening the customers by the insurance companies.

Genuine buyers of the insurance policies normally face larger risks as compared to other buyers who may be facing fewer risks and they only want to benefit from the coverage. The insurance companies normally charge higher premiums on buyers with heavier risks, for example, in the life insurance policies, the insurer may require medical examination and may deny coverage to individuals with terminal diseases. Also in the automobile industry, the insurance companies may charge higher premiums for drivers with drunken driving convictions.

The moral hazards refers to the prospects that an insured party may start behaving differently from the normal way he/she used to behave before coverage. It occurs when an institution or an individual do not bear the full consequences of the actions it engages in and may exhibit some careless tendencies. For example in the automobile insurance against theft, the owner may fail to keep vigilance on the vehicle and it may end up being stolen.

Moral hazards is related with asymmetry of information whereby one of the parties in a transaction has got more information about his/her intentions and actions than the other party who is paying for the consequences of the others actions. The insurer cannot perfectly monitor the actions of the insured and hence results in the moral hazards. Moral hazards are common in the management, finance and in the insurance industry.

The moral hazards normally occur whenever the insured individuals act carelessly due to lack of incentives to keep themselves safe because they have externalized their possible costs and therefore they know that they would not pay medical and other expenses out of their pockets since the insurance company would bear all the expenses.

The customers may also become more reckless and may cause severe accidents that result in huge claims and pay outs by the insurance companies hence premiums and rates would be driven higher. Insurance would try to mitigate this by refusing to cover certain individuals or groups, avoid a class of risk or raising the premiums. Insurance companies may use sex and age to deny coverage of certain individuals. Also some systems are expensive and inefficient and they benefit only the doctors and the insurers at the expense of the insured.

The pension plans which provide coverage to the members incase they suffer disability (e.g. blindness) is referred to as the disability insurance policies. Disabilities are incurable conditions such as accidents, assaults among others. The disability insurance plans are provided at all levels of the government arms ranging from the federal to the provincial levels. Also the private sector provides these policies.

The universal disability insurance cannot be accomplished purely by the private insurance due to the bureaucratic agencies. The victim’s recovery is complicated by the uncertainty and the anxiety which is caused by the unreliable private insurance companies. Adjudication and rules (common with private insurance) cause unnecessary delays in the victims’ compensation.