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 would be eliminated in this situation if:
A) the insurer would always charge $300.
B) the insurer would always charge $6000.
C) the insurer could costlessly monitor whether a fire prevention program has been implemented, and adjust the premium upward if it is not.
D) the insurer could costlessly monitor whether a fire prevention program has been implemented, and adjust the premium downward if it is not.
E) the fire did not occur.

Question

Quizplus · Accepted Answer

Moral hazard refers to the increased risk-taking behavior of insured parties because they are protected by insurance. In this scenario, if the insurer could costlessly monitor whether a fire prevention program has been implemented and adjust the premium upward if it is not, it would incentivize the factory owners to implement the fire prevention program and reduce the risk of a fire occurring. This would eliminate the moral hazard problem by aligning the incentives of both the insurer and the insured party. Option A and B do not address the issue of moral hazard, while option D is not feasible as adjusting the premium downward is not an effective deterrent for implementing the fire prevention program. The fire not occurring cannot be controlled, so option E is not a viable solution.

Scenario 17.3 Consider the Following Information