September 2014 Paper 1 Q3

[Ester]

In the examiner's report its written the following in the last paragraph " Can also design the policy to reduce moral hazard risk – e.g. base cover on cheapest supplier to avoid disincentive to shop around ".
I don't understand how moral hazard risk applies to this product..

 

[Helen Evans]

Moral hazard is about the behaviour of the insured changing because they have insurance in place. There is a risk of moral hazard for the policy in the question as if the cost of electricity rises above 1.05 per unit for all electicity providers in the market then the insured doesn't have an incentive to shop around for the lowest price electricity, and if they don't look to move to the lowest cost provider then there will be extra costs for the insurer. Here is a simplified example:

Imagine there are just 3 electricity providers in the market and an individual buys their electricity from company A, currently the cheapest. Now suppose the cost of electricity changes and all companies revise their rates to be above 1.05 to: Company A 1.20, Company B 1.15 and Company C 1.10, so now Company A is the most expensive.

If an individual has insurance there is no incentive for them to switch providers from Company A to Company C, as the insurer meets all the costs over the 1.05 unit price. If on the other hand an individual doesn't have insurance then they would move to Company C to save themselves money.