Which of the following are moral hazard problems? Which are adverse selection problems?

1. A person with a terminal illness buys several life insurance policies through the mail.
2. A person drives carelessly because she has automobile insurance.
3. A person who intends to torch his warehouse takes out a large fire insurance policy.
4. A professional athlete who has a guaranteed contract fails to stay in shape during the off-season.
5. A person who anticipates having a large family takes a job with a firm that offers exceptional child care benefits.

Adverse selection is a market failure that occurs at the time of signing a contract/agreement, where one of the concerned parties (seller) bears the cost of lack of information about the other party (buyer).

For example, a seller of an insurance policy might not be aware of the drinking habits of the buyer and thus bears the risk of this unknown information that can result in a huge loss for the company if the buyer has a liver failure.

A moral hazard occurs when one party (seller) bears the cost of bad decisions taken by another party (buyer)after a contract is signed.

For example, a buyer of car insurance might start rash driving and witness an accident. The seller will still have to pay the buyer irrespective of the buyer’s purposely engaging in activities that could result in a bad outcome.

If a person knows about his terminal illness and still manages to buy a number of insurances through the mail, then it is safe to say that the seller was unaware of the buyer’s health. The insurance company will have to bear the burden of this lack of information later when the person dies.

Since this happened at the time of the contract, and the illness was a piece of information that the buyer knew, but the seller of the life insurance did not know before entering a contract, this comes under an adverse selection problem.

The person knows that automobile insurance will cover the cost of any car accidents that might happen and, therefore, purposely engages in careless driving. The unaware seller will bear the cost of an accident irrespective of whether the buyer knowingly made the bad decision of careless driving or not. Since this happened after the contract or insurance was sold, this is a moral hazard problem.

The person intends to torch his/her warehouse and then buys fire insurance to make profits. The insurance seller is unaware of this fact, and therefore, gets into a contract with the buyer. The seller will bear the cost in the future of this lack of information. Since this happened at the time of selling fire insurance, adverse selection is a problem.

The professional athlete has a guaranteed contract that ensures his/her compensation during the contract duration, irrespective of the circumstances during this time. This certainty made the athlete take decisions that resulted in bad shape during the off-season. The other party of the contract will have to bear the burden of the low performance of the athlete and its associated cost.

Since this happened after the contract due to the guaranteed covering of losses for the athlete, it is a moral hazard problem.

If a person who wants a large family takes a job in a firm with exceptional child care benefits, he/she will enjoy the benefits when the time comes. This will put additional child care costs on the firm that anticipates a small to medium-size family when the job is offered to him/her.

Since the firm is not aware of this selection criterion of the person, the lack of information occurring at the time of employment contract puts this under an adverse selection problem.