Before reading this article on the Moral Hazard Problem, we encourage you to watch this video.
“Yeah, you better give me the insurance because I’m going to beat the HELL out of this car.” says Jerry Seinfeld in the episode ‘The Alternate Side’ when asked whether he wanted to buy insurance for the car he was renting. You see, Jerry is pissed because his car is stolen and the car he wants to rent for the time-being is unavailable, even after he made reservation for it. The rental company instead offers to provide him a substitute, a smaller compact car, which So he begrudgingly accepts. When asked if he wanted to buy insurance for the car he was renting, he replies in affirmation, while promising to “-beat the hell out of- “it!
While Seinfeld is simply entertaining us by speaking his mind out loud, we have to ask ourselves- Would a person with a car insurance take less care of his car to prevent it from being damaged?
After all, if the car is destroyed/crushed/demolished then the person simply has to report it to the insurance company and the company will give him the insurance money to replace it.
On the other hand, if no insurance is available, then he or she would have to take the maximum amount of care possible.
This lack of incentive for a person to take better care of his/her belongings (the car) when the burden of risk due to his/her actions is borne by someone else (insurance company) is called Moral hazard.
If the amount of care an owner provides to his car is observable or can be monitored or enforced properly, then the insurance company can reimburse its client on the basis of the care taken and there wouldn’t be any problem.
Very often, you will see that the insurance companies will draw different policies for different clients based on their past and present information, more precisely, on the choices they have made that influence the probability of damage. For e.g., if Seinfeld’s intention is revealed to the insurance company, he will have to buy the insurance at a higher rate than any other non-scheming person.
But is statistically discriminating between clients a good enough way for these insurance companies to circumvent Moral Hazard problem? While it can be effective in some cases, most of the times, companies cannot possibly anticipate all the actions based on their previous choices. Further, there are investigative costs to be considered if the companies think being more vigilant is the solution and move in that direction.
What works then, you may ask.
Notice the tradeoff described within a moral hazard problem: Companies sell full insurance to their clients; clients don’t face the full costs of their actions and choose to care less.
What the insurance companies then want is for their clients to face some part of the risk. That is, instead of offering a complete insurance, they offer to provide for a partial insurance where in the clients will have to pay an amount (called deductible) to claim any insurance money.
By making the consumers pay part of a claim, the insurance companies make sure that the consumer always has an incentive to take some amount of care.
If you were curious about what happened to Jerry’s rent-a-car, George rams it into an ambulance and Jerry has to pay two thousand dollars out of his own pocket as the insurance policy he bought did not cover the expenses if someone else was driving it during the accident. Bad intentions, eh?