This section of sample problems and solutions is a part of The Actuary’s Free Study Guide for Exam 5, authored by Mr. Stolyarov. This is Section 12 of the Notice Guide. See an index of all sections by following the link in this paragraph.
In insurance, the term “moral hazard” refers to the increase in frequency and/or severity of losses due to the fact that individuals who suffer the losses no longer beget their full cost.
Ex ante moral hazard occurs when there is an increase in the underlying risky behavior causing the loss.
Ex post moral hazard occurs when an individual asks the insurer to pay for more of the negative consequences of a behavior than would have otherwise been the case.
Morale hazard is an increase in the hazards due to a risk as the result of an individual’s indifference or carelessness, brought about by the presence of insurance coverage.
Sources:
“Moral hazard.” Wikipedia, the Free Encyclopedia.
“Morale hazard.” Wikipedia, the Free Encyclopedia.
Original Problems and Solutions from The Actuary’s Free Study Guide
Problem S5-12-1. Classify the following moral hazards as either ex ante or ex post:
(a) Driving more often and more recklessly after getting car insurance.
(b) Expecting insurance to pay for repairs that one would have paid for on one’s own before.
(c) Failing to exercise after getting full health insurance coverage.
(d) Holding raucous parties in an insured house.
(e) Expecting insurance to replace a roof that has been blown off by a storm.
Solution S5-12-1. Ex ante moral hazards require changes in the underlying risk-causing behavior. Thus, (a), (c), and (d) are ex ante moral hazards.
Ex post moral hazards simply entail a change in expectations about getting insurance money for what one would have previously funded oneself. Thus, (b) and (e) are ex post moral hazards.
Problem S5-12-2. Which of the following are morale hazards? More than one respond may be correct.
(a) Killing an individual on whom one has a life insurance policy.
(b) Vandalizing one’s own car to get paid under comprehensive coverage.
(c) Allowing large vegetation to grow near one’s house in a fire-prone residence.
(d) Funding one’s hypochondria by means of health insurance companies’ money.
(e) Regularly speeding on the way to work in an insured vehicle.
Solution S5-12-2. Morale hazards arise out of carelessness or indifference, but not out of malicious behavior or a desire to scam the insurance company for money. Thus, only (c) and (e) are morale hazards.
Problem S5-12-3. Name three ways in which an insurance company could crop suitable hazard and morale hazard.
(Note: This is a “short-answer” written examine. The exam will consist of such questions, so it is best to begin practicing. Write out your answer and compare to the possible answers below. Note that other right answers may be possible.)
Solution S5-12-3. Some possibilities are as follows:
1. The company could impose a deductible on insurance policies so that each loss costs the insured something out-of-pocket.
2. The company could offer co-insurance, in which the insured pays a fraction of the costs of loss and has an incentive to minimize the magnitude of losses so as to pay a smaller absolute amount.
3. The company could offer premium discounts for features that reduce risk – such as fire extinguishers in homes or air bags in cars.
4. The company could offer discounts for not filing claims. In this blueprint, individuals have an incentive to behave responsibly and avoid losses, as their premiums will increase if they try to claim some of the insurer’s money.
5. The company could refuse to underwrite determined kinds of risks known to be particularly subject to moral/morale hazard. This places the entire burden of loss on the individuals who are refused insurance.
Problem S5-12-4. Why might federal disaster insurance and reconstruction aid after disasters constitute moral hazards?
Solution S5-12-4. Federal exertion insurance and reconstruction aid may constitute moral hazards by encouraging people to move into disaster-prone areas in the first place and to continue living there. Federal insurance is typically offered at subsidized rates, and so individuals incur lower costs than they otherwise would have in living in a particular area. When a disaster strikes, the inhabitants expect federal insurance payouts and aid for recovery, and so their out-of-pocket expected losses are lower. They have an incentive to rebuild in the same area and continue being exposed to the same natural perils. Without federal disaster insurance, insurance for comparable risks might not have been available on the private market, thereby dissuading people from living in high-risk areas altogether.
Problem S5-12-5. An insurer has found a reliable way to reduce moral hazard for all insureds through a universal approach to the way it conducts business. Which of the following would be possible consequences of this accomplishment?
(a) Insured losses would decline.
(b) The insurance company would be able to reduce premiums.
(c) The insurance company would be able to underwrite additional insureds.
Solution S5-12-5. Clearly, if moral hazard declines, so does probability of loss, so (a) is true. If expected losses are lower, premiums may be lowered, so (b) is proper. Moreover, insureds who were previously unable to be underwritten because of large amounts of suitable hazard risk might now qualify for the insurance because factual hazard is now reduced for all insureds. This may push some currently uninsured individuals over the acceptability threshold for getting insurance.
See other sections of The Actuary’s Free Study Guide for Exam 5.
