Explain moral hazard and adverse selection in insurance markets. How do instruments such as excess, co-payment and no-claim bonus try to address them?

Insurance works only if the insurer can price each risk correctly. Two forms of information asymmetry undermine this: moral hazard and adverse selection. Excess, co-payment and the no-claim bonus (NCB) respond by making the insured carry part of their own risk.

Moral hazard and adverse selection

• Moral hazard (hidden action, after the contract): once insured, a person may take less care or use more services. Examples are careless driving, or extra hospital days when the full bill is paid by someone else.
• Adverse selection (hidden type, before the contract): high-risk people are the most eager to buy cover, and the insurer cannot fully tell them apart from low-risk people. Premiums then rise, low-risk buyers leave, and the pool gets worse. This risk grows as IRDAI's 2024 product rules open health cover to all age groups [2].

How the instruments address them

• Excess/deductible: the insured pays the first part of every admissible claim [1]. This keeps them exposed to loss, which curbs moral hazard. It also filters out small claims and cuts administrative cost [1]. When an insurer offers a higher voluntary excess for a lower premium, careful buyers tend to choose it and so reveal themselves. This helps screen against adverse selection.
• Co-payment: in health policies, the insured pays a share of every bill [1]. This checks over-use of hospital services.
• No-claim bonus: claim-free years earn a renewal discount or a higher sum insured [1]. This experience rating rewards care (moral hazard) and keeps low-risk customers in the pool (adverse selection).

Information asymmetry
 ├─ Hidden action → Moral hazard      → Excess, Co-payment, NCB
 └─ Hidden type   → Adverse selection → NCB, Voluntary excess

Fig.: Each problem and the instruments that address it

Limitations

• NCB trap: a valid ₹2,000 claim can wipe out ₹5,000 of renewal discount [1]. Genuine claims then go unfiled, so the NCB rewards not claiming rather than only safe driving.
• Health: people rarely choose to fall ill, so a co-payment mostly shifts cost back to families. Out-of-pocket spending was still 39.4% of total health expenditure in 2021-22 [3].

Excess, co-payment and NCB align each policyholder's incentives with the interests of the whole pool and keep premiums affordable. To work fairly, they need clear disclosure. IRDAI could require insurers to show the net cost of a claim when it is filed, and to state co-pay terms plainly. Cost-sharing would then strengthen the financial protection that SDG 3.8 (universal health coverage) aims for, rather than weaken it.