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 would be eliminated in this situation if:
A) the insurer would always charge $5000.
B) the insurer would always charge $10,000.
C) the insurer could costlessly monitor whether a flood control system is in place, and adjust the premium upward if it is not.
D) the insurer could costlessly monitor whether a flood control system is in place, and adjust the premium downward if it is not.
E) the flood did not occur.

Question

Quizplus · Accepted Answer

Moral hazard occurs when an individual or organization takes on more risk because they are insured. In this scenario, if the insurer charges a premium based on the assumption that the flood control system is in place, the insured may not actually implement the flood control system and still receive the lower premium. By monitoring whether the flood control system is in place and adjusting the premium upward if it is not, moral hazard is reduced as the insured has an incentive to implement the flood control system in order to receive the lower premium. Option D is not a solution, as it would actually increase moral hazard by incentivizing the insured to falsely claim that the flood control system is in place to receive a lower premium.

Scenario 17.4 Consider the Following Information