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FRM Exam Part I · Insurance Companies and Pension Plans

Moral Hazard vs Adverse Selection in Insurance

Updated 11 October 2026 · Fact-checked

Adverse selection occurs before the contract: high-risk people are the most eager to buy cover. Moral hazard occurs after: insured people take less care. Insurers respond with underwriting, risk-based pricing, deductibles, coinsurance and policy limits. Regulators add capital and reserve rules, such as Solvency II in Europe.

Understand Moral Hazard, Adverse Selection and Insurance Regulation

Insurance works because an insurer pools many similar risks. The insurer knows less about each person's risk than the person does. This gap in information causes two classic problems.

Adverse selection happens before the policy is sold. People who know they are riskier buy more cover, or buy it at the average price. If the insurer charges one average premium, low-risk people find it too dear and leave. The pool gets worse, claims rise, premiums rise, and more good risks leave. This is a hidden-information problem.

Moral hazard happens after the policy is sold. Once insured, a person has less reason to avoid loss, or may exaggerate a claim. This is a hidden-action problem. Examples: driving less carefully with full cover, or skipping maintenance.

Insurers cut both problems by making the policyholder share the loss. A deductible is a fixed amount the policyholder bears first. Coinsurance is a percentage share of each loss the policyholder bears. A policy limit caps what the insurer pays. Because the insured has money at stake, they take more care. These features also act as screening tools: low-risk people accept higher deductibles for lower premiums, which reveals their type. Insurers also use underwriting, risk-based pricing, experience rating, no-claims bonuses and claim investigation.

Regulation protects policyholders from insurer failure. Regulators require reserves for expected claims and capital above that. Solvency II (European Union) is risk-based and rests on three pillars: quantitative capital requirements, supervisory review and governance, and disclosure. It sets a Solvency Capital Requirement (SCR) calibrated to a 99.5% one-year VaR, and a lower Minimum Capital Requirement (MCR). US regulation is run state by state, with risk-based capital (RBC) formulas set through the NAIC. Know the contrast: Solvency II is a single, risk-sensitive EU framework; the US system is state-based.

Key formulas to remember

Claim payment with deductible
Payment = max(Loss − Deductible, 0)
Subject to the policy limit. The policyholder bears the first part of the loss.
Claim payment with coinsurance
Payment = Coinsurance share × Loss
If the insurer pays 80%, the policyholder bears 20%.
Combined deductible, coinsurance and limit
Payment = min(Limit, Insurer share × max(Loss − Deductible, 0))
Apply in this order unless the policy states otherwise: deductible, then share, then cap.
Solvency II SCR calibration
SCR ≈ 99.5% one-year VaR of own funds
Equivalent to a failure probability of about 1 in 200 years.

How to solve Moral Hazard, Adverse Selection and Insurance Regulation questions

Use this method for both concept questions and claim-payment calculations.

  1. 1Decide whether the problem is before the contract (hidden information, adverse selection) or after it (hidden action, moral hazard).
  2. 2Identify who knows more: the policyholder about their risk type, or the insurer about the policyholder's later behaviour.
  3. 3Match the tool to the problem: screening and risk-based pricing for adverse selection; deductibles, coinsurance and limits for moral hazard.
  4. 4For a calculation, list the loss, deductible, insurer share and limit.
  5. 5Compute in order: subtract the deductible, apply the insurer share, then cap at the limit.
  6. 6For regulation questions, name the framework (Solvency II or US state-based RBC) and its feature: risk-based capital, 99.5% VaR, three pillars.
  7. 7Check the answer: the insurer payment must not exceed the loss or the limit.

Quickest way: Timing and keyword shortcut

When to use it: Use it on conceptual multiple-choice questions where two options look similar.

  1. Ask: did the problem arise before or after the policy was signed? Before is adverse selection; after is moral hazard.
  2. Hidden type or characteristic means adverse selection; hidden behaviour means moral hazard.
  3. Deductible and coinsurance target moral hazard mainly, and also screen types.
  4. For payments, do deductible first, then percentage, then limit.
  5. For regulation, link 99.5% and three pillars to Solvency II, and state-by-state to the US.

Common mistakes in Moral Hazard, Adverse Selection and Insurance Regulation

  • Swapping moral hazard and adverse selection.

    Both come from asymmetric information and sound alike.

    Fix: Use timing: adverse selection is before the contract, moral hazard is after.

  • Applying coinsurance before the deductible.

    Students multiply the full loss by the share first.

    Fix: Subtract the deductible first, then apply the insurer's share, then the limit, unless the question says otherwise.

  • Forgetting the policy limit.

    The calculation looks finished after the share step.

    Fix: Always compare the result with the limit and take the smaller.

  • Saying deductibles only fix moral hazard.

    Textbooks stress the incentive effect.

    Fix: Remember they also screen: low-risk buyers choose higher deductibles, revealing their type.

  • Treating US insurance regulation as federal and uniform.

    Banking regulation is more centralised, so students assume the same.

    Fix: Remember US insurers are mainly regulated by states, with NAIC coordination; Solvency II is one EU framework.

  • Confusing the SCR with the MCR.

    Both are capital floors with similar names.

    Fix: SCR is the target, calibrated to 99.5% one-year VaR; MCR is the lower level that triggers the strongest supervisory action.

Worked examples

Example 1

A property policy has a ₹50,000 deductible, 80% insurer coinsurance and a ₹4,00,000 policy limit. A loss of ₹3,00,000 occurs. How much does the insurer pay?

Show the solution
  1. Subtract the deductible: 3,00,000 − 50,000 = 2,50,000.
  2. Apply the insurer share: 80% × 2,50,000 = 2,00,000.
  3. Compare with the limit: 2,00,000 is below 4,00,000, so the cap does not bind.

Answer: The insurer pays ₹2,00,000 and the policyholder bears ₹1,00,000.

Example 2

After buying full cover with no deductible, a company stops maintaining its fire sprinklers. Which problem is this, and which feature best reduces it? (A) Adverse selection, policy limit; (B) Moral hazard, deductible; (C) Adverse selection, underwriting; (D) Moral hazard, higher premium for all.

Show the solution
  1. The change in behaviour occurs after the contract is signed, so it is moral hazard.
  2. Moral hazard is reduced by making the insured bear part of the loss.
  3. A deductible does this directly. Underwriting screens before sale, which targets adverse selection.
  4. Option A and C name the wrong problem. Option D charges everyone and does not change incentives.

Answer: (B) Moral hazard, reduced by a deductible.

Exam tips

  • Always fix the timing first: before the contract is adverse selection, after is moral hazard.
  • In payment questions, check the stated order of deductible, coinsurance and limit before calculating.
  • Remember Solvency II facts: three pillars, SCR at 99.5% one-year VaR, MCR as a lower floor.
  • Expect contrast questions: Solvency II is risk-based and EU-wide; US regulation is state-based.

Practice questions from Insurance Companies and Pension Plans

Moral Hazard, Adverse Selection and Insurance Regulation in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Moral Hazard, Adverse Selection and Insurance Regulation: frequently asked questions

What is the difference between moral hazard and adverse selection?

Adverse selection is hidden information before the contract: riskier people buy cover. Moral hazard is hidden action after the contract: insured people take less care. The timing is the quickest way to tell them apart.

How do insurers reduce adverse selection?

They use underwriting, risk-based premiums, questionnaires and medical or inspection checks. They also offer a menu of policies, such as higher deductibles for lower premiums, so buyers reveal their own risk level.

How do deductibles, coinsurance and limits reduce moral hazard?

Each one makes the policyholder bear part of the loss, so they keep an incentive to avoid it. Limits also cap the insurer's exposure to large or exaggerated claims.

What is Solvency II?

It is the EU's risk-based regulatory framework for insurers. It has three pillars covering capital, supervision and governance, and disclosure. Its SCR is calibrated to a 99.5% one-year VaR.