In law and economics, moral hazard is the name given to the increased risk of problematical (immoral) behavior, and thus a negative outcome ("hazard"), because the person who caused the problem doesn't suffer the full (or any) consequences, or may actually benefit. Such a concern typically arises in the context of a contract (for example, an insurance policy).

Insurance and moral hazards

The most well known examples of moral hazard come from insurance. For example:

• Fire insurance increases the incentive to commit arson, especially if someone is operating a failing business and decides that they'd rather have the cash from the insurance proceeds on the buildings than the buildings themselves. (The value of a business often is based on profitability; after arson, the owner can claim the business was profitable.) In a worst case scenario (from the insurer's viewpoint), the building is over-insured or valuable contents are removed but claims are filed that they were destroyed in the fire.

  Many, perhaps most, police investigations of arson are the result of leads from suspicious insurance adjusters.

• More generally, having insurance discourages preventive measures, such as proper fire prevention. For example, the expectation of federal government disaster aid seems to encourage the residents of Malibu, California to let bushes and trees grow near their houses, as part of their landscaping. This increased vegetation raises the risk of fire damage to their houses. Equally, the prospect of federal aid may depress insurance premiums, thus providing people with an incentive to settle in hazardous areas. The CATO institute has argued that the federal government should not subsidise the reconstruction of New Orleans, for precisely this reason.

• Automobile insurance reduces the costs to insured people who have accidents, making people less cautious when driving (compared to how they would drive if they paid 100 percent of the damages they cause in an accident).

• In finance, low level of effort by the agent (employee) is called the "moral hazard problem" according to agency theory. The more autonomy the agent enjoys and the greater the information the agent possesses, and the greater the specialised knowledge required to perform the task, the greater the chances for the occurrence of moral hazard (Holmstrom, 1979)

The problem of moral hazards for insurance can't be eliminated, but can be minimized. For example:

• Getting detailed information to evaluate the value of what is being insured, rather than simply taking the word of the person buying the insurance.

• Requiring that there be a deductible (an initial up-front sum which the insured must pay out of his or her own pocket in case of a loss), and/or only paying out a percentage of the loss (say, 80 or 90 percent).

• Imposing conditions, such as the ownership of fire extinguishers (in the case of fire insurance), or offering price reductions (for example, if a burglar alarm is installed in a home).

Moral hazards in other areas

Rescue operations carried out by governments, central banks, or consortiums of financial institutions can encourage risky lending, if lenders know that in case of serious problems they will not have to take losses. Similarly, if governments know that inability to pay creditors will lead to yet more loans (to prop up finances), then they are less likely to have sound financial policies.

The term "moral hazard" is sometimes used in the context of economic deregulation. A supporter of deregulation might argue that guaranteed high wages and strictures on employment conditions create worker inefficiency and reduce industrial productivity by entrenching worker benefits regardless of the quality of their work. Conversely, an opponent of deregulation might argue that the removal of price controls will result in a morally hazardous situation where producers of a good collude to raise their prices, thus harming consumers. However, these arguments (and similar ones about welfare and unemployment benefits) are better categorized as being about perverse incentives or unintended consequences, since they do not involve contracts where the contract itself affects behavior.

Abraham Lincoln and an example of moral hazard

Abraham Lincoln was involved in a court case involving the moral hazard of a 19th-century Illinois law that exempted under-aged debtors from paying their debts. Two youngsters had hired a ploughing team, and advised by their lawyer, refused to pay. Lawyer Lincoln was engaged on behalf of the ploughing team to have the debt paid. Lincoln conceded the literal meaning of the law, but said that the boys should not be allowed to enter adult life with their names tarnished by a reputation for not paying their debts. Pointing his arm at the opposing lawyer, Lincoln castigated lawyers who prostituted their profession with such advice. The jury found for the ploughing team.

See also

• perverse incentive, unintended consequence
• free rider problem, principal-agent problem
• adverse selection
• feedback

External links

• Discussion of moral hazard and insurance by Robert Schenk
• Moral hazard and risk
• Moral hazard and health care

Asymmetric information | Market failure | Business ethics

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