Term life insurance works like this: You pay a monthly fee (the premium), and if you die then the insurance company will pay a (large) lump sum to a survivor of your choosing (e.g. your spouse). Often term life insurance will not pay out in the case of a suicide. Why not? Is this an example of adverse selection or moral hazard?
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The question here is why an insurance company will not pay out in case of suicide. This sort of rule is a way to avoid adverse selection, not a way to avoid moral hazard. To see why this is, let us look at the definition of these two problems.
Moral hazard occurs when people engage in risky behavior because they do not believe that they will be harmed by it. For example, if banks know that the federal government will bail them out if their loans go bad, they will be more likely to issue risky loans because they will not suffer if the loans go bad.
This problem does not apply in the case of suicide and insurance. The fact that someone is insured does not mean that they will be protected from harm if they commit suicide. This is not like the example of driving and seat belts from your other question. Insurance will not protect you if you commit suicide.
Adverse selection occurs when, as the link below says, “you do business with people you would be better off avoiding.” The reason that you do business with them is because they have more information than you. They know something that you do not. If you knew what they knew, you wouldn’t do business with them.
Suicide and insurance is an example of this. Let’s say that you know you are going to kill yourself and you go to buy life insurance. You know that you are about to die (and the insurance will have to pay) but they do not know. You have more information than they do. To avoid this kind of problem, the insurance company simply sets out a rule saying they will not pay out in the event of a suicide. This protects them from having people take advantage of them. This is a rule that protects them against adverse selection.
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