What is a Moral Hazard?

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Definition:

Moral hazard is a term in economics that refers to a situation where one party takes undue risks because they know someone else will pay for the cost of their actions – They are protected from the negative consequences of their risk taking.

🤔 Understanding moral hazard

Moral hazards most often happen when two parties enter some sort of protection agreement and there is information asymmetry between the groups – That is, they don’t have the same knowledge about the actions that occur after the contract is in place. In these cases, the chance of risky behavior by the protected party increases due to that protection being in place – They’re likelier to do what helps them since they won’t bear the full cost of their actions. The concept of moral hazard began in the insurance industry. Those with auto insurance, for example, are more incentivized to not lock their car than those without it since they know the insurance company will cover the cost of a stolen car. Since its origin, the term moral hazard has been adopted more broadly beyond the insurance industry – It now refers to any adverse reaction by one person in response to being shielded from the impact of their decision. To reduce moral hazard, it’s important to make sure that both parties have skin in the game – The insured needs to bear part of the cost of any consequences of their risky behavior.

Example

Imagine that the chief executive officer (CEO) of the fictitious XYZ, Inc. is planning to retire in a year. The CEO’s compensation package includes a performance bonus of $1 million if the company’s sales increase by at least 20 percent from the previous year. These conditions might create a moral hazard. This is because the CEO is in a position to take extraordinary risks for the company – If things work out, they get a $1 million bonus. If they don’t, they can retire without consequence, leaving the mess for the next CEO to clean up.

Takeaway

A moral hazard is like a child pushing the limits…

Most kids are notorious risk takers. They can frequently hurt themselves and get into dangerous situations. In part, this happens because they instinctively trust that their parents will be there to pick them back up when they fall. Similarly, a moral hazard happens when a person or organization acts in a risky manner because they know that they won’t have to bear the full cost of their actions. But parents have to balance protecting their children from injury with making them learn what not to do. Sometimes, that means allowing them to suffer the consequences of bad decisions. Otherwise, their child may not learn how to become a capable adult. In the same manner, to avoid moral hazard, it’s important that the insured party has something to lose so that they won’t be incentivized to be overly risky and rely on someone else to fully protect them.

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What is the difference between moral hazard and adverse selection?

While adverse selection and moral hazard are related – and often confused with each other – they are distinct concepts. The significant difference is that a moral hazard happens in response to protection from risk whereas adverse selection happens by hiding existing risks.

Moral hazard happens when a person changes their behavior because the consequences from something bad happening don’t matter as much since they are shielded from the risk in some way. A classic example of this is when a person is willing to drive more recklessly because they are wearing a seatbelt. In the worst cases, someone may violate generally accepted ethics. As an extreme example, a beneficiary – the person who benefits from something – might contemplate murder if a life insurance policy payout is large enough.

On the other hand, adverse selection refers to a risk that is already present, but can be hidden. For example, a person who is planning a dangerous life-threatening stunt might buy a life insurance policy without telling the insurance provider about their plan – They’re hiding the risk that is already present and making it likelier that the insurance provider will have to pay the consequences.

Similarly, a person who knows that they are sick might seek health insurance without informing the insurance company about their pre-existing illness. In these cases, the person can get an insurance policy that the company wouldn’t otherwise provide them if they had perfect – rather than asymmetric – information. That’s unfavorable for the insurer because it will be quite costly for them. This is adverse selection.

What is a moral hazard in auto insurance?

Automobile insurance can lead to moral hazards because it protects car owners and drivers from some of the risks they face. By shielding the policyholder from the financial consequences of their actions, auto insurance could encourage risky behaviors.

For instance, a car owner might become more willing to park on the street rather than in a garage because the insurance company would replace a stolen car. Likewise, someone purchasing rental car insurance might drive on more treacherous roads than someone who declines the coverage. A person might also become willing to drive faster and more recklessly because they feel safe from the cost of repairs.

Even a small moral hazard can occur due to auto insurance. Perhaps a person is more willing to park in places that are more prone to car damage. For example, if you didn’t have insurance that would repair a dent, you may park farther away from a baseball field. With coverage, however, you might reconsider and be more willing to risk the errant foul ball hitting your car so that you don’t have to walk as far to the field.

What is a moral hazard in health insurance?

The health insurance industry suffers from many moral hazards, and the term has been widely adopted in healthcare economics.

One common case of moral hazard happens when people decide to risk injuries because they know that they won’t have to pay for the full hospital bill. For example, a person might become willing to go rock climbing or bungee jumping once they have coverage. That increased risk taking can cause healthcare costs to increase for the insurer.

The growth in healthcare visits can also be considered a moral hazard. People may be willing to go to the doctor for issues that don’t require a medical diagnosis simply because they have the insurance. They wouldn’t usually seek medical care, but they do because they don’t have to pay for the visit.

Imagine a person going to the emergency room for a stuffy nose rather than just staying at home watching daytime television and eating chicken noodle soup. This interpretation stretches the standard definition of moral hazard, but the increased risk taking occurs in the form of seeking unnecessary care because you don’t have to pay for it.

Healthcare providers are also sometimes accused of moral hazard. A surgeon may be willing to perform a higher risk surgery because they have malpractice insurance. Conversely, a doctor may order additional testing because they are shielded from the cost and afraid of the consequences from a misdiagnosis.

What is a moral hazard in life insurance?

Moral hazards in life insurance are more concerning examples of the phenomenon. If a person would generally avoid dangerous situations because they fear leaving their family in poverty, a life insurance policy – which pays the beneficiary in the case of unexpected death – may help alleviate that worry.

Knowing that their family will be financially sound in case of death, the policyholder might be willing to do things that endanger their life. In the most extreme cases, a person might even proactively seek out ways to provide that payment to their family – They may intentionally take their life or attempt to defraud (aka lie to) the insurance company.

What is a moral hazard in banking?

Some of the most famous examples of moral hazards in banking happened leading up to the Great Recession – and, in part, contributed to it.

In the early 2000s, lenders would regularly sell their subprime home loans (for borrowers with a low credit) to investors. These investors would then create many financial products from all of these loans, including something called mortgage-backed securities (MBS) and collateralized debt obligations (CDOs). Both of these investment vehicles repackage debts into other securities (aka tradable financial assets).

Some academics have suggested that this dynamic led to the financial crisis. Lenders were eager to approve loans for risky borrowers because they wouldn’t experience the consequences if the borrower defaulted (aka didn’t pay) on their mortgage. Consequently, they were willing to lend large sums of money to borrowers who couldn’t afford to make the mortgage payments. In some instances, borrowers with no income, job, or assets could get approved for home loans.

This series of events can be considered a moral hazard because banks were willing to take on more risk because they were able to shift it to others. In theory, they became more lenient in their screening process and took far more risks than they may have if they had more at stake.

Further, some say that the government bailout in 2009 perpetuated moral hazards in banking. Opponents claim that the government shielded the financial institutions from their own risky behavior, and didn’t make them suffer the consequences. As a result, opponents fear that these massive financial institutions will again be willing to take excessive risks in the future because they know that the government will bail them out again.

Are moral hazards always bad?

People mostly talk about moral hazards in a negative manner and, in many cases, they are undesirable. Increased risk taking rarely results in better outcomes. Moral hazards in insurance markets make risk assessment and management more difficult. However, there are some examples where moral hazards generate desirable outcomes.

When a society wants to promote economic development, they usually want to encourage entrepreneurship and innovation. This means that people need to be willing to quit comfortable office jobs and take chances on ventures that provide less stable paychecks.

One way to promote people to take greater risks is to protect them from some of the consequences of failure – That is what bankruptcy laws and social safety nets are designed to do. While providing a reliable way to absolve a person or company of their debts does create the moral hazard of people taking on more debt and risk than they otherwise would, that isn’t always a bad thing. In this case, the moral hazard is precisely what the law is trying to accomplish in order to promote growth.

How do you reduce moral hazards?

A surefire way to reduce moral hazards is to ensure that people and companies have skin in the game. You generally can’t fully protect someone from the consequences of their decisions and expect them to care about the resultant costs.

In the insurance industry, companies typically implement copays, coinsurance, coverage limits, and deductibles for policyholders. This practice guarantees that the insured faces some financial responsibility for their actions.

Of course, direct physical consequences often deter moral hazards, as well. Most people don’t want to break a leg even if they don’t have to pay for the cast and crutches. The pain and inconvenience are themselves deterrents to the moral hazard.

In financial markets, regulators have put restrictions in place to thwart some risky lending practices. For example, the Dodd-Frank Act – a federal law passed in the wake of the 2008 financial crisis – includes a risk retention requirement for certain lenders. Under the original law, a lender who wanted to make a risky deal had to keep at least 5% of that risk – This provision was designed to act as a deterrent for underwriting risky loans. Other countries also have adopted “skin in the game” rules in their financial reform efforts.

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