Questions: Moral Hazard in Insurance and Contracting

Question 1

A homeowner purchases comprehensive flood insurance with full coverage and zero deductible. How does standard moral hazard theory predict their behavior will change?

• A. They will invest more in flood prevention because they now have more financial security
• B. They will reduce investment in flood prevention because the insurer bears the full cost of any loss
• C. Their behavior will not change because moral hazard only applies to car insurance
• D. They will invest the same amount in prevention because floods are uncontrollable anyway

Answer: (B)

Full coverage with zero deductible means the homeowner bears none of the financial cost of a flood loss. Any prevention effort (raised foundations, sump pumps, flood barriers) now has zero personal financial benefit — the insurer pays regardless. Moral hazard predicts that rational agents reduce effort when they do not bear the consequences of inaction. This is not dishonesty; it is the logical response to changed incentives. The insurer priced the policy assuming pre-insurance prevention levels, but behavior changes post-contract.

Question 2

What is the primary economic purpose of requiring insured parties to pay a deductible?

• A. To reduce administrative costs by discouraging small claims
• B. To penalize policyholders who file claims too frequently
• C. To preserve the insured's incentive to prevent losses by ensuring they bear some financial cost
• D. To allow insurers to offer lower premiums by transferring risk back to policyholders

Answer: (C)

Deductibles are incentive alignment tools, not punishments. By making the insured pay the first $X of any loss, the deductible ensures that prevention efforts have personal financial value — you still benefit from avoiding the first $X. Without any deductible, the full financial benefit of prevention accrues to the insurer, destroying the insured's motivation to take precautions. Reduced administrative costs (option A) are a secondary effect, but the primary function is preserving the insured's skin in the game.

Question 3

A deductible partially restores the insured's incentive to prevent loss by ensuring they bear the cost of small claims.

• T. True
• F. False

Answer: True

Yes — a deductible makes the insured the residual claimant on small losses. If you must pay the first $500 of any damage, you have a direct financial incentive to prevent incidents that would cost less than $500 (or even somewhat more). This is precisely why deductibles exist from an incentive standpoint: they keep some 'skin in the game' so the insured's interests partially align with the insurer's interests in preventing the loss.

Question 4

Full insurance with zero deductible is optimal for a risk-averse individual because it largely eliminates financial risk, which is the goal of insurance.

• T. True
• F. False

Answer: False

This ignores the incentive effect — the key insight of moral hazard. While full insurance maximizes risk-sharing (good for the risk-averse individual), it eliminates all incentive to prevent the insured event. The optimal contract under unobservable effort trades off risk-bearing against incentive provision: some risk must be left with the insured to maintain prevention motivation. Full coverage is only optimal if effort is observable (and can be contractually required) or if the insured event is entirely unpreventable.

Question 5

Why is complete insurance — full coverage with zero deductible — never optimal when the insured's effort is unobservable?

Model answer: Complete insurance removes all personal financial consequences of the insured event, which eliminates any incentive to take preventive action. Since the insurer cannot observe whether the insured is taking precautions, it cannot condition the contract on effort. Rational agents then reduce prevention to zero, increasing the probability of loss — at the insurer's full expense. The optimal contract balances the benefits of risk transfer (which argues for more coverage) against the need to maintain prevention incentives (which argues for deductibles and coinsurance). Some risk retention is always efficient when effort is hidden.

This is the core moral hazard result: information asymmetry about effort makes full insurance non-optimal even for genuinely risk-averse individuals. The insurer must make the insured a partial residual claimant to align incentives. The result has broad applications beyond insurance: employment contracts include bonuses and profit-sharing for the same reason — if employees bore no cost of poor performance, they would underinvest in effort.