Adverse Selection vs Moral Hazard
Moral hazard and adverse selection are both concepts widely used in the field of insurance. Both these concepts explain a situation in which the insurance company is disadvantaged as they do not have the full information about the actual loss or because they bear more responsibility of the risk being insured against. These two concepts are quite distinct to each other even though they are widely misinterpreted. The following article aims to provide a clear overview of what each concept is, alongside the explanation of how they are different to each other.
What is Adverse Selection?
Adverse selection is the situation in which an ‘information asymmetry’ occurs where one party to a deal has more up-to-date and accurate information than the other party. This can cause the party with more information to benefit at the expense of the party with less information. This is most prevalent in insurance transactions. For example, there are two sets of people in the population those who smoke and those who refrain from smoking. It is a known fact that non smokers have a longer healthier life than a smoker, however, the insurance company selling life insurance may be unaware of whom in the population smokes and who doesn’t. This would mean that the insurance company will charge the same premium to both parties; however, the insurance bought will be of more value to the smoker than the non smoker as they have more to gain.
What is Moral Hazard?
Moral hazard is a situation where one party benefits off the other party either by not providing full information about the contract that the parties are entering into, or in the insurance scenario, this would be when the insured takes more risks than they usually do because they know that the insurance company will payout if a loss occurs. The reasons for moral hazard include asymmetry of information and the knowledge that a party other than oneself will be bearing responsibility for losses incurred. For example, a person who has purchased life insurance may be willing to participate in high risk sports knowing that the insurance will cover any loss in the event that something happens to the insured.
Adverse Selection vs Moral Hazard
Adverse selection and moral hazard always result in one party benefiting over the other mainly because they have more information or they bear lower levels of responsibility which make way for acting recklessly. The difference between the two is that adverse selection is when the party providing the service (such as an insurance company) is unaware of the full length of the risk because all information is not shared when entering into the contract, and moral hazard occurs when the insured knows that the insurance company bears the full risk of loss and will reimburse this to the insured if they suffer a loss.
Summary:
Difference Between Adverse Selection and Moral Hazard
• Adverse selection and moral hazard always result in one party benefiting over the other mainly because they have more information or they bear lower levels of responsibility which make way for acting recklessly.
• Adverse selection is the situation in which an ‘information asymmetry’ occurs where one party to a deal has more up-to-date and accurate information than the other party.
• Moral hazard occurs when the insured knows that the insurance company bears the full risk of loss and will reimburse this to the insured if they suffer a loss.