Chapter EMC, Problem 3CYU

a)

To determine

To state: Whether it is true or false, people with higher deductibles on their auto insurance drive more carefully.

Explanation of Solution

Yes, indeed, people with higher deductibles on their auto insurance drive more carefully.

Insurance companies manage moral hazard by using a deductible: they reimburse for losses only above an assured amount, so that coverage is always less than 100%.

For example, in the case of car insurance, the insured has to pay for repairs after the first $600 in the loss. So, this means that an insensitive driver who gets collides with another vehicle will end up paying $600 for repairs even if it is insured, which gives at least some reason to be careful and reduces the moral hazard.

Economics Concept Introduction

Introduction:

Moral hazard rises when individuals have more knowledge about their actions than others. This results in the falsification of incentives to apply or to take care of effort when someone else tolerates the costs of the lack of effort or care.

A deductible is defined as a sum stated in an insurance policy that the insured persons must pay before being reimbursed for a claim; a deductible is an instrument used by the insurance company to reduce moral hazard.

b)

To determine

To state: whether it is true or false, people with higher deductibles on their auto insurance pay less premium.

Explanation of Solution

Yes, people with higher deductibles on their auto insurance indeed pay less premium.

Not only reducing moral hazard, but deductibles also provide a limited solution to the difficulty of adverse selection. The insurance premium is lower in case the customer is willing to accept a large deductible. This is a very alluring option for those people who know that they are low-risk customers, and it is a very less alluring option for the people who know they are high-risk—and are most likely to have an accident and may end up paying the deductible.

So, by offering a list of policies with different deductibles and premiums, insurance companies can monitor their customers, persuading them to categorize themselves based on their private information.

Economics Concept Introduction

Introduction:

Moral hazard rises when individuals have more knowledge about their actions than others. This results in the falsification of incentives to apply or to take care of effort when someone else tolerates the costs of the lack of effort or care.

A deductible is defined as a sum stated in an insurance policy that the insured persons must pay before being reimbursed for a claim; a deductible is an instrument used by the insurance company to reduce moral hazard.