What Is a Moral Hazard?

Risk and reward often go hand in hand. If you take a risk, you pay a price when things go wrong, and you can get ahead if the risk is worth it. But when "moral hazard" is at stake, things work differently.

Moral hazard is a situation where someone has limited liability for the risks they take and the costs they create. As a result, that person or organization may have an incentive to take more risks than they would otherwise, because they don't have to pay for them. If they take risks and everything works out, they win. And if things go wrong, but someone else pays the price, the consequences of taking risks are minimal.

The concept of moral hazard is important for insurance because people may be inclined to take greater risks if they are insured than if they are not. Most people do not intend to take advantage of an insurance company. Doing so may be illegal, unethical, or unpleasant. But if you see that your risks are limited, moral hazard can creep into your mental calculations.

How moral hazard works

When moral hazard occurs, one person or entity has the opportunity to take advantage of the other. That person may take unexpected risks or incur costs that they will not have to pay, no matter what happens next. The concept applies to all types of insurance.

For example, an insurance company could sell a car insurance policy to a customer. In this case, the insurer is liable for damage to the vehicle - or caused by the vehicle - and the customer pays the insurance premiums for this protection.

The customer may find that there is less risk of reckless driving if the insurer pays (almost) everything. For example, the customer may drive at high speeds on slippery roads knowing that the insurer will likely pay for the damage to the vehicle. Even if the customer goes off the road and destroys a fence, the insurer may still be liable for payment.

Moral Hazard in Insurance

With insurance, moral hazard can lead people to take higher risks or incur higher costs than they would otherwise. In a situation where moral hazard exists, there is often a mismatch between the amount of information each party has about the risks involved.

To continue with the previous example, the insurer can reasonably assume that drivers generally want to avoid accidents. Insurers use statistics to get an idea of ​​how much risk is present in the general population, but they cannot know what is on each customer's mind.

Most drivers probably want to get to their destinations safely, but some people may be tempted by the potential benefits of taking excessive risks.

Moral hazard can also be a factor in life insurance. When a person believes that they are likely to die, they may be motivated to purchase insurance coverage. This belief can arise from knowledge of health conditions or suicidal ideation, and insurers have several strategies to reduce risk.

To manage their exposure to risk, insurers often conduct a thorough review of an applicant's health history, occupation, and potentially risky hobbies, and may even require a medical examination. Also, insurers may not pay a death benefit if the insured dies by suicide within two years from the policy issue date.

Adverse Selection

Moral hazard is related to "adverse selection" or the tendency of people with higher levels of risk to purchase more generous insurance coverage. When people believe that they are likely to suffer a loss, they may prefer that another entity, such as an insurance company, pay the costs. Someone who thinks they are in good health might opt ​​for a simple health insurance plan, while people with health problems might want more robust coverage.

Other examples of Moral Hazard

Moral hazard exists in several areas besides insurance. Whenever a person can take a risk that other people can pay for, moral hazard is a factor. For example, this phenomenon may have contributed to the mortgage crisis that peaked in 2007-2008.

Before the crisis, lenders were eager to make a profit by originating loans, but they often sold those loans to investors. Without a "skin in the game," they had little incentive to manage risk and ensure that borrowers could repay loans.

As a result, lenders did not always verify that borrowers had sufficient income and assets to qualify for large mortgages. By selling these loans, lenders could avoid the consequences if borrowers later defaulted on their mortgages.

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Source: Marginal Revolution University

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