How does the adverse selection problem faced by insurance companies differ from the moral hazard problem they face? How might an insurance company deal with each problem?
What will be an ideal response?
In the adverse selection problem, one group starts out being poorer risks than another group, but the insurance company cannot distinguish between the two groups. In the moral hazard problem, people incur additional risks as a result of being insured. One way an insurance company can deal with adverse selection is to limit the amount of insurance that can be purchased at the lowest rates. The limit discourages "poor risks" from purchasing the policies designed for "good risks" and causes the two groups to voluntarily separate themselves. To deal with moral hazard, an insurance company may require observable modifications in the consumer's behavior (e.g., air bags in automobiles or deadbolt locks on doors). The insurer can also provide subsidies and information to elicit the desired behaviors.
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