Moral hazard

Moral hazard is the prospect that a party insulated from risk may behave differently than it would if it were fully exposed to the risk. For example, an insured party's behaviour might be more risky than it would have been without the insurance. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions.

For example, an individual with insurance against automobile theft may be less vigilant about locking his car, because the negative consequences of automobile theft are (partially) borne by the insurance company.

Moral hazard is related to asymmetric information, a situation in which one party in a transaction has more information than another. A special case of moral hazard is called a principal-agent problem, where one party, called an agent, acts on behalf of another party, called the principal. The agent usually has more information about his actions or intentions than the principal does, because the principal usually cannot perfectly monitor the agent. The agent may have an incentive to act inappropriately (from the view of the principal) if the interests of the agent and the principal are not aligned.

Moral hazard in finance
Financial bail-outs of lending institutions by governments, central banks or other institutions can encourage risky lending in the future, if those that take the risks come to believe that they will not have to carry the full burden of losses. Lending institutions need to take risks by making loans, and usually the most risky loans have the potential for making the highest return. A moral hazard arises if lending institutions believe that they can make risky loans that will pay handsomely if the investment turns out well but they will not have to fully pay for losses if the investment turns out badly. Taxpayers, depositors, other creditors have often had to shoulder at least part of the burden of risky financial decisions made by lending institutions.

Moral hazard can also occur with borrowers. Borrowers may not act prudently (in the view of the lender) when they invest or spend funds recklessly. For example, credit card companies often limit the amount borrowers can spend using their cards, because without such limits those borrowers may spend borrowed funds recklessly, leading to default.

Moral hazard in insurance
In insurance markets, moral hazard refers to the case where the existence of the insurance changes the behaviour of the insured party, since the insured party no longer bears the full costs of that behaviour. For example, after purchasing automobile insurance, some may tend to be less careful about locking the automobile or choose to drive more, thereby increasing the risk of theft or an accident for the insurance company. After purchasing fire insurance, some may tend to be less careful about preventing fires (say, by smoking in bed or neglecting to replace the batteries in fire alarms).

Before purchasing medical insurance, some may be more careful about maintaining their health through their own actions because they must bear the full financial cost of health care, and by implication, after purchasing medical insurance, may be less careful about maintaining their health. For example, an obese person has an additional incentive to lose weight if he believes that he must pay for any health care costs resulting from his unhealthy condition.

Deductibles, copayment, and coinsurance reduce the risk of moral hazard since the insured have a financial incentive to avoid making a claim.

Moral hazard has been studied by insurers and academics. See works by Kenneth Arrow and Tom Baker.

History of term
According to research by Dembe and Boden, the term moral hazard dates back to the 1600s and the phrase was used widely by English insurance companies by the late 1800s. Early usage of the term seems to have carried negative or pejorative connotations and implied fraud or immoral behavior (usually on the part of an insured party). However, Dembe and Boden point out that prominent mathematicians studying decision-making in the 1700s used "moral" to mean "subjective," which may cloud the true ethical significance in the term.

The concept of moral hazard was the subject of renewed study by economists in the 1960s and didn't, at that time, imply immoral behavior or fraud. Use of the term moral hazard by economists tends to focus more on the inefficiencies that can occur when risks are displaced rather than on the ethics or morals of the involved parties.