Question

The classic application of market failures ascribed to adverse selection and moral hazard were found in the health insurance markets. Adverse selection caused market failure in health insurance because insurers were unaware of the health risks their customers faced. They overcame this market failure by taking detailed medical histories and asking about risky practices such as smoking or extreme sports. Moral hazard caused market failure because insurers weren’t able to monitor customer behaviour (e.g., weight gain, drug use, taking up extreme sports) after customers signed a contract at a fixed price. This risk of market failure was commonly mitigated through co-payment terms where the customer had to pay part, but not all, of the costs of treatment. How would these two kinds of market failure apply to owners and managers of business firms in absence of any measures to alleviate the risks? What measures have been taken, or could be taken, to reduce adverse selection and moral hazard between owners and managers of business firms? Hint: consider who has an information advantage in this setting.

Answer 1

Moral hazard and adverse selection are key concept used in risk management aspect and by insurance company , Moral hazard is more common occurs with asymmetric information between parties of insurance contract. Adverse selection happened with a lack of symmetric information before buying between both parties.

In Moral hazard in insurance transaction when party provide a false information or alterations in behavior as believe not to have any consequences for such action. Generally entity intentionally takes additional risk because insurance company is ready to bear the loss. It may happen after an insurance policy start.

Steps to reduce moral hazards:

• Use of concept of Deductibles in policy contract
• Penalty of many activities
• Calculate Insurance Scores
• Good behavior and claim benefits
• Reduction in future premium with change in moral

Adverse selection explain a condition when an entity in contract has different information than next entity in the same contract. The entity with a smaller amount information is always on disadvantage. Such asymmetry leads to reduction in efficiency. To reduce the net impact of adverse selection , every information should link with price or cost.