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FRM Part I · FRM Exam Part I · The Building Blocks of Risk Management

A firm buys property insurance with a large deductible and a policy limit. Which statement best describes the effect of the deductible on the insured's behavior and the insurer's risk?

A deductible reduces moral hazard because the insured must retain the first part of each loss and so has an incentive to prevent losses. It does not eliminate adverse selection or shift catastrophic risk to the insurer, whose exposure is capped by the policy limit.

  1. AIt increases moral hazard by lowering the insured's share of small losses
  2. BIt transfers all catastrophic losses back to the insurer
  3. CIt reduces moral hazard by making the insured retain part of each lossCorrect
  4. DIt eliminates adverse selection entirely by identifying high-risk firms

Explanation

A deductible makes the insured bear the first portion of any loss, giving an incentive to take care and so reducing moral hazard. It also removes small, frequent claims for the insurer. It does not eliminate adverse selection, and the policy limit, not the deductible, caps insurer exposure.

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