Scenario 17.4
Consider the following information:
StowUrStuff Storage is located slightly below sea level in a coastal town. It could build and maintain a flood control system around its property at an annual cost of $1000, and if it did so, the probability of a flood's doing $1,000,000 in damage during the year would be .005. With no flood control system, the probability of such a flood would be .01.
-Refer to Scenario 17.4. Moral hazard arises in this situation because once the firm:
A) pays the premium that is based on the .005 probability, it has no incentive to spend the additional $1000 for the flood control system, so the true probability of loss is no longer .005.
B) pays the premium that is based on the .01 probability, it has no incentive to spend the additional $1000 for the flood control system, so the true probability of loss is no longer .01.
C) provides for flood control, it has less incentive to spend $5000 on premiums, leaving itself underinsured.
D) provides for flood control, it has less incentive to spend $10,000 on premiums, leaving itself underinsured.
E) provides for flood control, it will consider that a substitute for insurance and not be able to deal with the loss from a flood should it occur.

Question

Quizplus · Accepted Answer

Once the firm pays the premium based on the lower probability of .005, it may feel that the flood control system is not necessary and therefore not spend the additional $1000. This would result in a higher probability of loss than what was originally calculated, leading to moral hazard.

Scenario 17.4 Consider the Following Information