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

An insurer offers a motor policy with a fixed premium and no deductible. After the policy is sold, policyholders begin driving less carefully because they no longer bear the cost of accidents. Which term describes this problem?

This is moral hazard: after buying insurance, policyholders take less care because the insurer, not they, bears the cost of losses. It is a post-contract change in behavior, unlike adverse selection, which concerns who chooses to buy cover before the contract.

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

Explanation

Moral hazard is the change in behavior after insurance is bought, when the insured bears less of the loss. Adverse selection arises before the contract, when high-risk people are more likely to buy cover. Basis risk and longevity risk are unrelated to this behavior.

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