Elizabeth has an automobile accident and finds as a result that her auto insurance premium will increase 25%. This is an example of an adjustable premium that insurance companies often use as a mechanism to combat:
A free-riders
B short-sightedness
C moral hazard
D adverse selection
The correct answer and explanation is:
The correct answer is C. moral hazard.
Explanation:
Moral hazard refers to the situation where individuals or entities take on more risk because they do not have to bear the full consequences of that risk. In the context of insurance, moral hazard occurs when people engage in riskier behavior because they know they are protected by insurance. For example, Elizabeth might have driven more recklessly or been less cautious knowing that her insurance would cover the costs of an accident.
To mitigate moral hazard, insurance companies often adjust premiums based on claims history or behaviors. In this case, Elizabeth’s premium increases by 25% after her accident, which is an attempt to correct for the risk associated with her behavior or past claims. This higher premium is designed to discourage risky driving and encourage safer behavior, as the person will have to pay more if they are involved in an accident.
This practice of adjusting premiums is a common strategy that insurance companies use to align the cost of coverage with the level of risk that the policyholder presents. By increasing premiums for those who have higher claims or more accidents, insurers reduce the likelihood that policyholders will take advantage of their coverage.
While the other options also relate to insurance issues, they are less relevant here:
- A. Free riders refers to individuals who benefit from a service without contributing to its cost, which is not the case here.
- B. Short-sightedness involves a focus on immediate benefits over long-term consequences, which does not directly apply to the premium increase.
- D. Adverse selection is when higher-risk individuals are more likely to purchase insurance, but it does not specifically explain the premium increase after an accident.