2.3 In each of the following situations, moral hazard or adverse selection may b
ID: 1167677 • Letter: 2
Question
2.3 In each of the following situations, moral hazard or adverse selection may be present. Indicate which you think is present, if any, and explain your choice.
a. An insurance company is thinking about issuing health insurance to a firm’s employees.
b. An insurance company has issued health insurance to a firm’s employees on the basis of their medical histories
c. An investor has purchased shares in a new software company. He is just a shareholder, and is not going to be involved in the daily operations of the firm.
e. A grandfather has just given his grandson $100 as a birthday present.
2.4 In each of the situations considered in question 2.3, what could be done to overcome the problem?
Explanation / Answer
(Question 2.3 & 2.4)
(a) Issuance of employee health insurance may provide employees incentive to be careless and negligent about their own health, knowing that the insurance will cover for any health expenses. The burden has to be borne by the insurer. So, this is a Moral hazard problem.
To mitigate this, the insurance may limit a ceiling to the health expenses borne by insurer.
(b) In this case, employees with existing medical problems will be more willing to take up the insurance, therefore insurer will leave the healthier customer base out. This is an adverse selection.
To mitigate this, the insurance may limit a ceiling to the health expenses borne by insurer, as well as exclude existing diseases outside scope of the policy.
(c) There is a moral hazard. Even if the investor is shareholder, since he is not involved in everyday operations, firm can take riskier decisions knowing the investor will not be involved. This creates moral hazard.
This can be mitigated by conducting regular general shareholder meetings about firm performance.
(e) The grandson can spend the $100 carelesslessly & recklessly, thus creating a risky situation. This is a moral hazard.
Here, no formal action can prevent the grandson from taking riskier acts. At most, grandfather can warn him on allowable usages of the $100 that he gifts.
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