Testing for loss severity: Impact on loss reduction

Abstract This paper examines moral hazard in insurance when individuals are faced with different loss reduction functions and able to test for loss severity with results potentially being observed by insurers. It is important to distinguish between the types of loss reduction, that is, monetary or physical effort‐based, and the functional form of loss reduction costs to account for different loss reduction strategies meant for different types of risks. With monetary loss reduction costs, individuals tend to engage in identical levels of loss reduction regardless of the functional form. With effort‐based loss reduction, the individual with higher severity engages in more loss reduction although this does not necessarily hold when the functional form of loss reduction costs is concave. Identifying the optimal loss reduction has implications on insurance decisions, hence individuals can be motivated to test to discover their severity level.