Moral Hazard in Risk Pooling Arrangements

Abstract

The authors examine risk pooling arrangements with moral hazard. Because of the nature of the risk pooling arrangement, full nominal coverage is shown to be optimal, despite the presence of moral hazard, and positive loss-prevention effort levels are induced even at full nominal coverage. When marginal utility is convex and higher-order utility effects are sufficiently small, as the number of members in the pool increases, the effort levels of members decrease and, as the pool size approaches infinity, effort levels approach zero. The latter result suggests that moral hazard may define an optimal size for risk pooling arrangements.