What is it about?
Insurance companies often face two information problems. First, customers may know more about their own risk than insurers do, creating adverse selection. Second, after obtaining insurance, customers may change their behavior in ways that affect the likelihood of a loss, creating moral hazard. These two problems can occur at the same time, but they are often studied separately. This study develops a theoretical model that examines how insurers can design contracts when adverse selection and moral hazard coexist and interact. The model explores how insurance coverage and premiums can differ across customers with different risk characteristics.
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Why is it important?
Adverse selection and moral hazard are fundamental problems in insurance markets, and considering them separately may not fully capture the challenges insurers face when designing contracts. Our model incorporates both problems simultaneously and produces a richer set of possible insurance market outcomes than models that consider only one information problem. Among its findings, the model preserves important results from traditional insurance theory, including less than full insurance and a positive relationship between insurance coverage and risk type. It also examines how optimal coverage and premiums respond to changes in factors such as potential losses, the cost of effort, and the insured's initial wealth
Perspectives
The motivation for this study came from recognizing that adverse selection and moral hazard can coexist and interact in insurance markets, even though they are often analyzed separately. We wanted to develop a theoretical framework that considers both information problems simultaneously and provides a more comprehensive understanding of insurance contracting under asymmetric information. Our analysis shows that combining adverse selection and moral hazard can produce richer outcomes than models that consider either problem alone. I hope this study contributes to a better understanding of how information asymmetry affects the design of insurance contracts and provides a useful foundation for further research in this area.
Dr. Hongbok Lee
Western Illinois University
Read the Original
This page is a summary of: Insurance Contracting with Adverse Selection and Moral Hazard, Journal of Finance Issues, December 2023, Academy of Finance,
DOI: 10.58886/jfi.v21i2.6558.
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