premiums in the future. The insurance company is likely to believe that, on average, having a major accident is

a signal of being a high-risk driver, and thus try to charge this driver higher insurance premiums. The next two

sections discuss the two major problems of imperfect information in insurance markets—called moral hazard

and adverse selection. Both problems arise from attempts to categorize those purchasing insurance into risk

groups.

The Moral Hazard Problem

Moral hazard refers to the case when people engage in riskier behavior with insurance than they would if they

did not have insurance. For example, if you have health insurance that covers the cost of visiting the doctor,

you may be less likely to take precautions against catching an illness that might require a doctor’s visit. If you

have car insurance, you will worry less about driving or parking your car in ways that make it more likely to get
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