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.
Moral hazard is a situation in which someone has limited responsibility for the risks they take and the costs they create. As a result, that 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. And if things go badly—but somebody else pays the price—the consequences of risk-taking are minimal.
The concept of moral hazard is important for insurance because people may be inclined to take bigger risks if they’re insured than if they’re not. Most people have no intention of taking advantage of an insurance company. Doing so may be illegal, unethical, or otherwise unappealing. But if you realize that your risks are limited, moral hazard might creep into your mental calculations.
How Moral Hazard Works
When a moral hazard happens, one person or entity has the opportunity to take advantage of the other. That person 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 damage to the vehicle. Even if the customer skids off the road and destroys a fence, the insurance company might still be responsible for payment.
The customer may need to pay a deductible and live without a vehicle while repairs are completed, and there may be civil or criminal charges for reckless behavior. Still, with a comprehensive policy, the financial cost may be relatively low.
Moral Hazard in Insurance
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. Most drivers probably 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 may even require a medical exam. In addition, insurance companies might not pay a death benefit if the insured dies by suicide within two years of the policy’s issue date.
If you are having suicidal thoughts, contact the National Suicide Prevention Lifeline at 1-800-273-8255 for support and assistance from a trained counselor. If you or a loved one are in immediate danger, call 911.
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 may want more robust coverage.
Adverse selection affects your decisions regarding whether or not to buy coverage (and how much to buy). Moral hazard affects decision-making after you have insurance coverage in place.
Other Examples of Moral Hazard
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 2007-2008.
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 later defaulted on their mortgages.
- Moral hazard involves one party taking risks that others will have to pay for.
- Those who pay the costs often lack complete information about those who take the risks.
- Moral hazard may exist in a variety of spheres, including insurance, lending, investing, and more.