What Is Moral Hazard?
Moral hazard is the risk that arises when a party engages in a contract without good faith or has provided misleading information about its assets, liabilities, or credit capacity. Additionally, moral hazard may imply that a party has the incentive to take unusual risks in an attempt to earn profit before the contract settles. These risks can occur anytime two parties come into an agreement, wherein each has the opportunity to gain by acting contrary to the agreement’s principles. The likelihood of moral hazard increases when a party does not have to face the potential consequences of a risk.
Key Takeaways
- Risk Without Consequences: Moral hazard can exist when a party in a contract can take risks without facing the consequences.
- Prevalent in Multiple Fields: It’s common in the lending and insurance industries but can also occur in employment relationships.
- Historical Example: Preceding the 2008 financial crisis, some homeowners’ willingness to walk away from a mortgage showcased unforeseen moral hazards.
Understanding Moral Hazard
A moral hazard occurs when one party in a transaction has the opportunity to assume additional risks that negatively affect the other party. This decision is based not on what is good or ethical but on what brings the highest level of benefit. These can apply to activities in the financial industry, such as the borrower-lender contract, and in the insurance sector.
For instance, when a property owner obtains insurance, it is based on the notion that they will avoid situations that could damage the property. Due to the availability of insurance, the owner might be less inclined to protect the property, since the insurance payout lessens their burden in case of a disaster. Moral hazards also exist in employer-employee relationships. If an employee has access to a company car without paying for repairs, they might be less careful, hence taking risks with the vehicle. Also, during financial crises, the demand for stringent government regulations often rises.
Examples of Moral Hazard
Prior to the 2008 financial crisis, actions from lenders could qualify as moral hazards. For example, a mortgage broker might be incentivized to originate as many loans as possible, regardless of borrowers’ financial situations. These questionable loans, often sold to investors, shifted the risk away from the lending institution. Hence, mortgage brokers and lenders reaped financial gains while investors shouldered the risk.
Borrowers struggling with mortgage payments faced moral hazards too. When property values decreased, making their homes worth less than their mortgages, some homeowners might have chosen to abandon the property, reducing their financial burden.
In insurance scenarios, if someone buys the latest cell phone with insurance, they might be less careful, assuming it will be replaced no matter their level of care. This assumption creates a moral hazard, driving up insurance costs for everyone.
What Does Moral Hazard Mean?
In economic terms, moral hazard occurs when a party lacks the incentive to guard against a financial risk due to being protected from potential consequences.
How Do You Manage Moral Hazards?
Minimizing moral hazards involves several strategies:
- Encouraging Responsible Behavior: Offering incentives for responsible actions.
- Governance Policies: Instituting policies that discourage unethical behavior by making it punishable.
- Regular Monitoring: Keeping an eye on the parties to ensure they do not exploit the agreement.
The Difference Between Moral Hazard and Adverse Selection
While moral hazard involves taking risks without facing consequences, adverse selection occurs when one party uses information that the other doesn’t have to secure a favorable deal. For example, someone with a high-risk lifestyle taking out a life insurance policy exemplifies adverse selection, whereas an employee less concerned about oral hygiene due to having dental insurance illustrates moral hazard.
The Bottom Line
Moral hazards can cost businesses heavily. Learning to identify and mitigate them is crucial for any business’s profitability and longevity. Implementing practices, or offering incentives that give the risk-taking party ‘skin in the game,’ are effective ways to tackle this issue.
Related Terms: adverse selection, risk management, financial risk, insurance fraud.
