Hi all I still don't understand why underinsurance is a kind of moral hazard even after reading the explanation in the note (see Chapter 2 - 1.3) for a few times. To my understanding, if the policyholder chooses a policy with sum insured of $20,000, the maximum amount that the insurer will need to pay is capped there. Accordingly, the insurer should charge a lower premium. What's wrong here? Does anyone have other explanations on this term? Thank you!
Well over my head, but that's never stopped me before The point of moral hazard in general is that someone may choose to take a risk in the knowledge or belief that he will be relieved if the risk materialise. So a bank may decide that it is too big too fail, take on silly amounts of risk, become illiquid, be bailed out, and continue trading. In an insurance context, I remember reading a comment somewhere that people in Victoria, Australia chronically underinsure, because their main risks are serious natural disaster, such as bushfires (as last year). After these disasters, the state government steps in with rebuilding help, and so the incentive to take out insurance is reduced. Does this make sense? And is it relevant? Like I say, ST7 is over my head, but sometimes it just takes a stupid person explaining something stupidly Cheers, Calum
Information Asymmetry Moral hazards are an issue when one party has information on the extent of the risk and withholds it from the other party in this case the insured not telling the insurer the true value of contents. Since the value of things is a key factor in pricing the risk appropriately under-insuring is a moral hazard. If a person with property worth 1 million insures their property for 200 000 there is a problem. A person with 1 million worth of property is very likely to be susceptible to higher claims on average than a person who truly has property worth 200 000. This means the insurance company will end up paying for claims that are higher on average than it had thought. Hence the problem.
The key is that the premium paid by the insured is not adequate. If the premium rate of full coverage $20K is 0.5%, for example, the true rate for underinsurance with SI $15K should be higher than 0.5%. However, it may be the case that all the insureds, regardless of underinsured, use the same rate 0.5%, which implies moral hazard.
Yup - agreed. Its a hazard to the insurer specifically because if the sum insured is understated, so will the premium and (by extension) the exposure the insurer believes is on the books. The insured gets a cheap(er) premium as if there was less loss potential when the reality is not so. So by the definition of moral hazard, the insurer would have been taken advantage of.
