The Influence of Premium Subsidies on Moral Hazard in Insurance Contracts

Subsidized insurance premiums are present in nearly all public and some private insurance systems. Such subsidies are usually implemented to increase participation in the insurance program and to decrease the effects of adverse selection in the market. It has been argued that the increased demand for insurance due to subsidies also increases the market inefficiencies stemming from moral hazard in the market. While this argument is intuitive and some empirical evidence exists for it, it ignores the wealth effects of premium subsidies and their effect on moral hazard. We argue that such effects can be dominating for the majority of the insured, particularly in insurance markets where most insured do not have a choice between different insurance policies, as is sometimes the case, e.g. in health insurance. Our theoretical model shows that wealth effects do influence the moral hazard in a given insurance market and that the influence depends on contract design. The results offer policy implications for premium subsidies in public insurance systems calling for a differential treatment of premium subsidies in insurance systems with different premium schedules. One example for this is a different effect of premium subsidies in health insurance and long term care insurance.