Risk and reward usually go together. If you take a risk, you pay a price when things go badly, and you can come out ahead if the risk pays off. But when “moral hazard” is at play, things work differently. For example, an insured person or organization may have an incentive to take more risks than they otherwise would, because they don’t have to pay for them. If they take a risk and it goes well, they win. If things go badly, but somebody else pays the price, the consequences of risk-taking are minimal.
How Moral Hazard Works
When a moral hazard happens, one person or entity has the opportunity to take advantage of the other. They can take unexpected risks or incur costs that they won’t have to pay for, no matter what happens next. The concept applies to all types of insurance. For example, an insurance company might sell a car insurance policy to a customer. In that case, the insurer is responsible for damage to the vehicle—or caused by the vehicle—and the customer pays insurance premiums for this protection. The customer might realize that there is less risk in driving recklessly if the insurance company pays for (almost) everything. For example, the customer might drive at high speeds on slick roads, knowing that the insurance company is likely to pay for any potential damage to the vehicle. Even if the customer were to skid off the road and destroy a fence, the insurance company might still be responsible for payment.
What It Means for Insurance Companies
With insurance, moral hazard can lead people to take bigger risks or incur larger costs than they otherwise would. In a situation where moral hazard is present, there is typically a mismatch between the amounts of information each party has about the risks involved. To continue the example above, the insurance company might reasonably assume that drivers typically want to avoid accidents. Insurance companies use statistics to get an idea of how much risk is present in the general population, but they can’t know what’s going on inside the mind of every customer. Drivers want to get to their destinations safely, but some people may be tempted by the potential benefits of taking outsized risks. Moral hazard can also be a factor in life insurance. When a person believes they are likely to die, they might be motivated to purchase insurance coverage. That belief may arise from knowledge of health conditions or from suicidal ideation, and insurance companies have several strategies for reducing risk. To manage their risk exposure, insurers often conduct a thorough review of an applicant’s health history, occupation, and potentially risky hobbies, and they may even require a medical exam. They also might not pay a death benefit if the insured dies by suicide within two years of the policy’s 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 they are likely to suffer a loss, they may prefer to have another entity—like an insurance company—pay the costs. Someone who believes they’re in good health might opt for a no-frills health insurance plan, while people with health issues might want more robust coverage.
Notable Happenings
Moral hazard exists in several areas beyond insurance. Whenever a person can take a risk that others may pay for, moral hazard is a factor. For example, this phenomenon may have contributed to the mortgage crisis that peaked in 2007 and 2008. Leading up to the crisis, lenders were eager to earn profits by originating loans, but they often sold those loans to investors. With no “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 off those loans, lenders could dodge the consequences if borrowers were later to default on their mortgages.
