Scenario 17.3
Consider the following information:
The probability of a fire in a factory without a fire prevention program is 0.01. The probability of a fire in a factory with a fire protection program is 0.001. If a fire occurred, the value of the loss would be $300,000. A fire prevention program would cost $80 to run.
-Refer to Scenario 17.3. Moral hazard arises in this situation because once the firm:
A) pays the premium that is based on the 0.001 probability, it has no incentive to spend the additional $80 for the fire protection program, so the true probability of loss is no longer 0.001.
B) pays the premium that is based on the 0.01 probability, it has no incentive to spend the additional $80 for the fire protection program, so the true probability of loss is no longer 0.01.
C) puts the fire protection program in place, it has less incentive to spend $300 for a premium, leaving the firm underinsured.
D) puts the fire protection program in place, it has less incentive to spend $6,000 for a premium, leaving the firm underinsured.
E) puts the fire protection program in place, it will consider that a substitute for insurance and not be able to deal with the loss from a fire should it occur.

Question

Quizplus · Accepted Answer

Moral hazard arises in this situation because the firm may be incentivized to only pay the lower premium based on the lower probability of fire, and neglect to invest in the fire prevention program that could further reduce the probability of fire. As a result, the true probability of loss may be higher than the stated probability, leading to a potential increase in the cost of premiums or underinsurance.

Scenario 17.3 Consider the Following Information