The Insurance Market

Those who decide to purchase insurance come across moral hazard, and the insurance companies deal with adverse selection. Moral hazard takes place because a person that has insruance against a loss has less motivation than a person that may be uninsured to avert a loss. In class, the example we were presented with was a person who has car theft insurance has less incentive to lock their car as opposed to a person who does not have car theft insurance.

Insurance companies have to figure our ways to work around the moral hazard and adverse selection issues, which can be done by separating the high-risk from the low-risk clients. For instance, they can lower premiums for low-risk clients and raise them for high-risk clients. A particular example of such a situation can be made of an auto insurance company that offers a "no-claim" bonus, in which the insurance company lowers payments for their client if that client does not make a clain within a particular amount of time. Other ways are by offerring different deductible rates. A lower deductible with a higher amount of monthly payments is offered to high risk clients and a higher deductible with a lower amount of monthly payments is offered for the low risk clients.