Page 410 - DECO401_MICROECONOMIC_THEORY_ENGLISH

Unit-29: Insurance Choice and Risk

1. Moral Hazard Notes

This situation exists when a person, who is insured for illness, fire or car accident, behaves as the chances
of that incident become higher. In this situation, the loss is shifted from person to insurance company
and bears the big payment. Moral hazard happens when a person is speeding with his car or does not
lock from the theft and it increases for the accident or theft. Thus, home owner or firm does not put
fire system after fire insurance which increases the risk of fire. For health, an insured person gets chain
smoker and gets higher of his risk of illness. As these types of situation, the behaviour of policy taker
does change. He takes more risk than cover a policy.
The insurance policy does not give premium in favourable or fair odds due to moral hazard. It includes
some unique behaviour to protect or lower the moral hazard. For example, an insurance company can
sell policy to a firm or a home owner if the fire system is used; a person gets life insurance if he does
the annual checkups; and the premium can increase for multiple accident drivers. Thus the insurance
companies can decrease the number of payments by lowers the possibilities of fire, illness or accident.
They can present various agreements to various customers. High premium is taken from high risk
people and they get full protection, while low premiums are taken from lower risk people and they will
get only partial protection.
Think about a people whose cost of house is W. If it catches fire then his money only W = W – d, where
2
d is wastage of his house. If that person gives α premium and insured his house from fire then he
1
will get α payment if house catches fire. If no fire then his money will W = W – α which is insurance
1
1
2
premium which he pays. If it catches fire then his money will W = W – d+ α .
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2
An insurance company due to risk averse, to decrease the moral hazard, presents his customer to some
less favorable odds. This is shown in Fig. 29.2. Point P represents the cost of his house without any
insurance. In the situation of fire, his money will decrease till OF. It assumes that the possibility of
situation of fire from situation of fire is multiple of three times means 3:1. This indicates by the sloping
of his budget line B which gives possibility of 1/3 (3 to 1). Now assume that the home owner gets
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insurance policy. To assume that fire happens from possibility 1 to 3, he selects point E on which his
budget line B touches indifference curve I . Point E is risk free point for home owner which is with 45
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1
degree line because α = NN . After paying the policy premium, his money is W = W – α or ON = OF .
1 1 1 1 1 1
So he does not think about fire and here the possibility of fire is maximum. Please note the 45 degree
line has W = W or W – d + α = W – α , so the payment of insurance company covers only the losses of
2 2 1
home if fire catches. Thus the insurance policy will never present him to possibility 3 to 1. This condition
is shown in Fig. 29.2. The equilibrium point of home owner is R on which his budget line B touches
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his indifference curve I . On this R point, he pays NN premium but if catches fire, he will get payment
2 1
lower insured money OF rather than old insurance money OF .
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1
Fig. 29.2
W
1
Moral Hazard 45°
No Fire N N 1 P R E I I 1

2
B
1
B
2
45°
A
FF F Fire W
2
1
2
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