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FRM Part I · FRM Exam Part I · Insurance Companies and Pension Plans

An auto insurer discovers that after introducing a policy with very low deductibles, policyholders become less careful about locking their cars and parking in safe areas, so claim frequency rises. Which term best describes this problem?

This is moral hazard. Once the policyholders are covered by low deductibles, they take less care and claims rise, because the change in behavior occurs after the contract starts. Adverse selection would instead involve high-risk people choosing to buy insurance in the first place.

  1. AMoral hazardCorrect
  2. BAdverse selection
  3. CBasis risk
  4. DLongevity risk

Explanation

Moral hazard arises when the insured's behavior changes after coverage is in place, because the insured no longer bears the full cost of a loss. Adverse selection, by contrast, concerns who buys the policy before coverage begins, based on hidden risk characteristics. Here the behavior changed after purchase, so it is moral hazard.

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