Moral Hazard

Reviewed by Stefan Tirschler

Noun

mo·ral ha·zard | ˈmɔrəl ˈhɔzɚd

Definition: The risk that a party will act differently when protected from risk than they would with no protection.

Some insurers may be concerned about the moral hazard of bicycle owners not taking care to lock their bicycles because they know they are insured.

What is moral hazard?

When two parties enter into a formal agreement together, each party generally expects that the other party is acting in good faith. That is, they are disclosing every bit of information that’s important to the other party and to the agreement, and they intend to abide by the terms of that agreement.

Moral hazard arises when one of the parties to an agreement does not act in good faith. Specifically, moral hazard comes about when a party takes advantage of agreements that shield them from risk, taking excessive risks that they wouldn’t normally take.

Put differently, moral hazard arises from information asymmetry—when the parties to an agreement each have different information. The party that has more information could use that to their advantage and profit from it, or take much larger risks than they otherwise would.

One well-known, theorized example of moral hazard comes from the financial world: the 2007-2008 financial crisis.

Some large banks may have believed they were “too big to fail,” and that government would step in to bail them out if they suffered major losses. Many banks took exceptional financial risks (with potentially massive payoffs) that they might not have otherwise taken; some assumed that any downside to those risks would be covered by government bailouts.

Whether or not the banks did so intentionally, if they took careless risks because they believed themselves to be shielded from the downside of those risks, it’s an example of moral hazard.

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Moral hazard in insurance

Moral hazard can present itself anywhere in the insurance world.

Any time someone has insurance protecting themselves or their property, they may feel more comfortable taking risks with that property “because it’s insured.” Even if this extra risk-taking is completely unintentional, it can still constitute moral hazard.

When an insurance company agrees to cover something, they assume (or would like to assume) that their customer is going to continue taking proper care of the object of insurance, whether it’s a car, a business, or a house—and most people do.

But, there exists the chance of insurance customers securing their insurance contract and immediately taking more risks with their property that they wouldn’t have taken beforehand. Here’s an example of moral hazard in insurance:

Example

Russ is a life-long cigarette smoker. He’d always smoked outside to avoid the small chance of starting a fire inside his house. He also had never bothered with home insurance before.

However, now he’s changed his mind. He’s just purchased a new home insurance policy, which of course covers fire damage to his house. With his policy in place, Russ decides it would be fine to smoke indoors from now on… if the worst should happen, his insurance company would cover the cost of repairs.

This is just one example of moral hazard. While Russ may not be intentionally taking advantage of his insurer, he’s still taking a risk knowing that his insurance provider is going to cover any downside to that risk.

Insurance companies have several mechanisms they use to deal with the moral hazard issue.

For example, insurance applications may seem overly complicated, but they ask all those questions so the insurer can feel reasonably confident that they have all the information they need to issue a policy with the correct coverages (and price) for the situation.

Deductibles are another way that insurance companies deal with the moral hazard issue. When an insured has to pay the first portion of a claim (the deductible), they’re more likely to take actions that reduce the chance of a loss occurring.

The important points

  • Moral hazard exists when one party to an agreement has an incentive to change their behaviour or take more significant risks after the agreement is in place, knowing they are protected by the terms of the agreement.
  • In insurance, moral hazard occurs when insureds (intentionally or not) take larger risks knowing their insurance will cover any losses.
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