Question

Moral Hazard

Suppose a new startup in Davis wants to offer bicycle insurance to students and it goes like this: Students pay a fixed yearly premium for bicycle insurance. If students are in a bicycle accident that is not their fault, the startup will pay to fix the students' bicycle, or, if the bicycle is totaled, to replace the bicycle with one of equal value. If students are in a bicycle accident and it is their fault, the startup will not owe them anything.

7.1 Explain moral hazard in this setting.
7.2 What are three factors that determine the level of moral hazard in this setting?
7.3 What are two possible things that the bicycle insurance company could do to decrease moral hazard and to increased      production efficiency in this setting?

Answer 1

7.1 Moral hazard means a person getting into a risk by less caring about it because he knows that the risk is insured and hell not be affected by it. The people don’t care because they have nothing to lose.

In this case, moral hazard would the asymmetric information of the faulty. The company wouldn’t know in the case of accident if the fault is of student or not.

7.2 Factors that determine the level of moral hazard are credibility of student, policies of company and the premium amount.

7.3 Two possible things that the bicycle insurance company could do to decrease moral hazard and to increased production efficiency in this setting are-

1. By enforcing restrictive covenants on student
2. By having a financial intermediation that checks all the activities and background checks.