How Do Insurance Companies Account For Moral Hazard
Insurance companies try to mitigate moral hazard by structuring policies that incentivize behavior that does not lead to claims and penalizing actions that do. It can also take the form of more practical strategies like deductibles and premium reduction for fewer claims. It’s a constant balancing act, however, as insurers struggle to create a fair system given the limited information they have about those who purchase their policies.
Example Of A Moral Hazard
Lets say you just bought a shiny new bike. You love your bike, and take care of it to make sure nothing happens you lock it every time, take your seat with, and make sure not to park it anywhere someone could damage it.
Then, you hear of something called renters insurance, which protects your bike among other stuff against things like theft, fire, windstorms, hail, etc. You get an insurance policy, and suddenly feel much more relaxed at the thought of your bike being snagged. Who cares if my bikes stolen, you think. My insurance company will just get me a new one.
Based on that, you decide to be lazy you stop locking your bike and taking your seat with you, unbeknownst to your insurance company.
This, my friend, is a moral hazard.
What Is A Moral Hazard
A moral hazard is an idea that a party protected from risk in some way will act differently than if they didn’t have that protection. We encounter moral hazard every daytenured professors who become indifferent lecturers, people with theft insurance becoming less vigilant about where they park, salaried employees who take long breaks, and so on.
Moral hazard is usually applied to the insurance industry. Insurance companies worry that by offering payouts to protect against losses from accidents, they may actually encourage risk-taking. This often forces them to pay out more in claims. Insurers fear that a “don’t worry, it’s insured” attitude often leads policyholders with collision insurance to drive recklessly or fire-insured homeowners to smoke in bed.
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Matching Insurance Coverage To Policyholder Risk
For insurers outside the health care context, the struggle is to adjust premium rates in order to account for the real risk of coverage. Moral hazard increases the risk, not necessarily because of deliberate fraud, but because of lack of care as a result of knowing that the item is fully covered. If an item is insured against theft, the company may reason that the probability that it is stolen against the payout cost in the event of a claim is the monetary risk. That risk changes once coverage is in place, but only because people become less cautious about preventing theft.
For example, a $5,000 jet ski may have a 5 percent chance of loss through theft, leading to a risk amount of $250. If the jet ski is insured, theft is more likely, so the company may reason it is now 25 percent, or $1,250. Because of moral hazard, insurance companies therefore have to use strategies to account for this difference. These include:
- Higher premiums
- Lower premiums with proof of mitigation against risky behavior
The insurance company also wants to make policies affordable. However, this can create a perpetual push-and-pull to find a fair and financially sound insurance policy. In an ideal scenario, insurers would have the maximum information about insureds as possible, in order to most effectively define the risk.
How To Reduce Moral Hazard
The root cause of moral hazard is asymmetric information. In the health industry, moral hazard happens when you behave in a way that increases the cost for the insurer.
Individuals who do not have to pay for medical services tend to seek more expensive and even riskier services that they would not require otherwise.
For these reasons, health insurance providers institute co-pay and deductibles. These require individuals to pay partially for the services they get. Such a policy of deductible amounts is a consideration for the insured to cut down on services and avoid making claims.
You can remove moral hazard by reflecting the price with accurate information. The decision to smoke cigarettes or go paragliding looks different when it means increased premiums.
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How Does Moral Hazard Affect Health Insurance
It is easy to misinterpret moral hazard in the health insurance industry. Many argue that health insurance itself is a moral hazard because it reduces the risks of pursuing an unhealthy lifestyle or other unsafe behavior.
This stands valid only if the costs to the customer, like insurance premiums and deductibles, are the same for everyone. However, in the competitive market, insurance companies charge higher premiums to riskier customers.
Regulatory Response To Moral Hazard
This moral hazard threatens the viability of the LLR, and it therefore evokes an adaptive response by the central bank in the form of restrictions on bank behavior, such as legal cash-asset reserve requirements. These, together with sanctions for their violation, have clear analogs in private contracting. A fire insurance policy typically reduces the vigilance of the insured and thereby shifts additional risk to the insurer. The insurer reacts by requiring that the insured maintain minimum safety standards, and violations void the insurance coverage. In the case of deposit-taking banks, a large part of public regulation can be explained as protective responses to the moral hazards arising from safety-net provisions provided by the government. The most important among these are the LLR facility, deposit insurance, protection of the payments system, and the too-big-to-fail policy.6 All of these create moral hazards that shift costs and risks from the private banks to the public and, therefore, elicit restrictions on bank behavior designed to limit such exploitation.
Georges Dionne, Scott E. Harrington, in, 2014
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Distinguishing Moral Hazard From Access For High
Roles Data curation, Formal analysis, Methodology, Visualization, Writing review & editing
Affiliation Department of Economics, University of Arizona, Tucson, Arizona
Roles Data curation, Formal analysis, Visualization, Writing review & editing
Affiliation Department of Economics, University of Arizona, Tucson, Arizona
Roles Conceptualization, Funding acquisition, Methodology, Writing original draft, Writing review & editing
Affiliation Department of Economics, University of Arizona, Tucson, Arizona
Moral Hazard And Health Care
Moral Hazard is a term that Economist are familiar with when discussing market failures, or the inefficient allocation of resources. The definition of moral hazard is when there is hidden action taken by one party that incurs costs of another party. But this is just the definition of the term, what does moral hazard truly mean in everyday life? One example that is brought up a lot is when an auto mobile owner becomes more of a reckless driver and justifies it by saying, Its fine, I have car insurance. Obviously auto insurance doesnt quite work this way, but moral hazard does allow for inefficient allocation in other insurance markets, such as the health insurance market.
Health Insurance in the US has been a political topic for the past 40 years and it still surrounds every political debate. But as economists, we should take a look at this market from an economic angle. Insurance can come in many different forms, not just monetary value. For instance, one can insure themselves from deadly head injuries when riding a bicycle by wearing a helmet. If this person does a wear a helmet they are more likely to take risks that they normally wouldnt on their usual bike ride. But because they know that they have a safety net to protect themselves, they are willing to take these risks. This type of behavior is where moral hazard comes into play when discussing the health insurance market.
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Moral Hazard In Health Insurance
Throughout this paper, we follow decades of health insurance literature and use the term moral hazard to refer to the responsiveness of healthcare spending to insurance coverage. The use of the term in this context dates back at least to Arrow . Consistent with the notion of hidden action, which is typically associated with the term moral hazard, it has been conjectured that health insurance may induce individuals to exert less effort in maintaining their health. For example, Ehrlich and Becker modeled health insurance as reducing individuals effort in maintaining their health because health insurance covers the financial costs that would be caused by poor health behaviors, individuals may have less incentive to avoid themthey may exercise less, eat more cheeseburgers, and smoke morewhen they have insurance coverage.
However, this so-called ex ante moral hazard has received very little subsequent attention in empirical work from the literature.2 This may be because it is not empirically relevant in many contextsthe increased financial cost associated with poor health is not the only cost, and probably not the most important cost of being sick.
Explainer: What Is Moral Hazard
The term “moral hazard”is heard frequently in discussions about how to reform thehealth care system and the financial sector. For example, in a recentspeech about regulating the financial system, Federal Reserve chairman Ben Bernanke said,”As we try to make the financial system safer, we must inevitably confront theproblem of moral hazard.” And a recent Boston Globe editorial on Obamacare said, “There is the risk of moral hazard: People might sign up only whenthey are sick. That would make the system too expensive to sustain.”
What is moral hazard?
Moral hazard is a term describing how behavior changes whenpeople are insured against losses. If, for example, your car is fully insuredagainst any and all damage and there is no deductible, then you would have noincentive to avoid minor accidents, like scratches or backing into poles, beyondthe inconvenience of getting the car fixed. You would be much more likely totake risks that could lead to minor car damage knowing that any damage is fullycovered.
How does this apply to the financial sector? If thegovernment is forced to bail out “too big to fail” banks to avoid catastrophicconsequences for the entire economy, then bankers effectively have government insuranceagainst losses. This gives them the incentive to take more risks when theyinvest the money that is deposited with them, and that increases the chance of afinancial crisis and that a bailout will be necessary.
What is the solution to moral hazard?
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What Is Moral Hazard In Insurance
The primary assumption behind a moral hazard is that an individual in a transaction takes on unnecessary risks that affect the other party in the transaction.
Lets assume the idea that a corporation is too big to fail. However, if the management of the company believes they will receive financial assistance to keep it going, they may take more risks in order to get profit.
In the insurance sector, risk and reward usually go together. If you take a risk, you pay the price when things go wrong. However, you can come out ahead if the risk pays off. But when moral hazard economy is in play, things work differently.
A moral hazard is a situation where someone has limited responsibility for the risks they take. Consequently, that person or organization may have an incentive to take on more risks than they otherwise would because they dont need to pay for them.
The concept of a moral hazard is essential for insurance because people may be inclined towards taking more significant risks if they are insured than if they are not. Moreover, most people have no intention of taking advantage of an insurance company. Doing so may be dishonest, illegal, and unappealing. But moral hazards might get into your subconscious calculations if you realize that your risks are limited.
Justification For The Detrimental Effects Of Moral Hazard
In agreement with Pauly , moral hazard escalates disparity in healthcare provision. Regardless of the heated debate and need for high deductibles, these are largely imposed on an individual because employer-provided insurance benefits pose a challenge to the implementation of such plans. Dave and Kaestner mention, moral hazard is associated with avoidance of preventive practice instead, individuals take up more of the unhealthy behaviors that tend to overwhelm the health care system. Dave and Kaestner are seconded by Stanciole , who shows a similar behavioral pattern associated with moral hazard. Despite the fact that such effects are realized based on empirical and opinion facts, feasible frameworks to ensure responsible behavior in preventive care and medical utilization are paramount.
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Moral Hazard And The Affordable Care Act
The act is 2,500 pages long, so it’s really difficult to discuss its impact with any brevity. So, here’s a look at some of the basic provisions outlined in the law:
- Insurers can no longer deny coverage to those with pre-existing conditions
- New government health insurance exchanges are to be set up to determine the type and cost of plans available to consumers
- Large employers are required to offer employee health coverage
- All plans must cover the 10 essential benefits of health insurance
- Annual and lifetime limits on employer plans are banned
- Plans are only affordable if the cost is less than 9.5% of family income
The act also carried with it an individual mandate, the requirement that all uninsured Americans must to purchase a health insurance policy or pay a fine, although there were hardship exemptions put into place for those who couldn’t afford coverage. Signed in 2010, the individual mandate went into effect in 2014. There was a reason behind this. People who were generally fairly health would decline coverage in order to save the added expense of a health insurance premium. In order to compensate for lost revenue, insurance companies would raise rates, putting more financial stress on those who had coverage. Under the mandate, anyone who didn’t have coverage would pay the penalty through their federal income tax return.
Do Individuals Respond To Dynamic Incentives
Once we recognize that the treatment of the nonlinear budget set can be consequential for this out-of-sample translation, the first question is whether in fact individuals take the dynamic incentives that are associated with the nonlinear budget set into account. A fully rational, forward-looking individual who is not liquidity constrained should take into account only the future price of medical care and recognize that the current spot price on care is not relevant, and should not affect healthcare utilization decisions. However, there are a number of reasons why individuals might respond only to the spot price. They may be unaware of or not understand the nonlinear budget set created by their health insurance contract, they may be affected by an extreme form of present bias and behave as if they are completely myopic, or they may wish to factor in the future price but be affected entirely by the spot price due to liquidity constraints.
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What It Means For Insurance Companies
With insurance, moral hazard can lead people to take bigger risks or incur larger costs than they otherwise would. In a situation where moral hazard is present, there is typically a mismatch between the amounts of information each party has about the risks involved.
To continue the example above, the insurance company might reasonably assume that drivers typically want to avoid accidents. Insurance companies use statistics to get an idea of how much risk is present in the general population, but they cant know whats going on inside the mind of every customer. Drivers want to get to their destinations safely, but some people may be tempted by the potential benefits of taking outsized risks.
Moral hazard can also be a factor in life insurance. When a person believes they are likely to die, they might be motivated to purchase insurance coverage. That belief may arise from knowledge of health conditions or from suicidal ideation, and insurance companies have several strategies for reducing risk. To manage their risk exposure, insurers often conduct a thorough review of an applicants health history, occupation, and potentially risky hobbies, and they may even require a medical exam. They also might not pay a death benefit if the insured dies by suicide within two years of the policys issue date.
Iii Descriptive Evidence Of Moral Hazard
We start by presenting some basic descriptive evidence of moral hazard in our setting, where by the term moral hazard we refer to the incremental medical spending associated with greater coverage, as defined in Section I. The analysis provides a feel for the basic identification strategy for moral hazard, as well as some suggestive evidence of heterogeneity in moral hazard and selection on it. At the same time, our descriptive exercise points to the difficulty in identifying heterogeneity in moral hazard and selection on it without a formal model of plan selection. The suggestive evidence as well as its important limitations together motivate our subsequent modeling exercise, which we turn to in the next section.
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The New Theory Of Demand For Health Insurance And Its Normative Consequences
41In the introduction to his book on the theory of demand for health insurance, Nyman tells why he became interested in the topic. Following the debates on the so-called Clinton plan to implement universal health insurance in the US, Nyman read numerous stories of non-insured or poorly insured Americans who could not afford care that they obviously needed and wanted, and paid for that lack of access with pain, disability, or sometimes the loss of a family member. He then compared those testimonies to the conventional welfare analysis of moral hazard in health insurance, which considers the level of health care utilization of the uninsured as the optimum and any level of utilization beyond that as producing a deadweight loss. He concluded that economists were missing something important.
43Nymans objection to this story is that, precisely, the share of ones budget going to health care spending should be part of the discussion on the demand for coverage: as the testimonies during the discussions of the Clinton reforms showed, individuals wanted to spend more on health when sick, but could not, because their level of income did not allow them to do so. The level of spending of at least some among the uninsured was certainly not optimal and they would have been happier if they could have transferred income to themselves when sick and used that extra income to spend on health care.