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Encyclopedia > Moral hazard

Moral hazard refers to the prospect that a party insulated from risk (such as through insurance) will not fully account for the negative consequences of the risk when deciding to act. Moral hazard arises because an individual or institution in a transaction does not bear the full consequences of its actions, and therefore has a tendency or incentive to act less carefully than would otherwise be the case, leaving another party in the transaction 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 car 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 may have an incentive or tendency to act inappropriately from the view of the principal, if the interests of the agent and the principal are not aligned. The agent usually has more information about his actions or intentions than the principal does, because the principal usually cannot perfectly monitor the agent. In economics, information asymmetry occurs when one party to a transaction has more or better information than the other party. ... In economics, the principal-agent problem treats the difficulties that arise under conditions of incomplete and asymmetric information when a principal hires an agent. ...

Contents

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.[1]


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 insured party behaves in a way that transfers the burden of the risk to the insurer, such that the insurer would consider inappropriate if it were fully aware of that behavior. The insured party has more information about its actions and intentions than the insurer and has a tendency or incentive to act in an inappropriate way in the view of the insurer because the insured party does not carry the full burden of or fully pay for the consequences of its actions. Image File history File links Emblem-contradict. ...


After purchasing automobile insurance, some 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 tend to be less careful about preventing fires (say, by smoking in bed or forgetting to replace the batteries in fire alarms) and may even have an incentive to commit arson in the case where they own business property but believe that insurance payments covering the loss of fire would be greater than the value of the business itself. The Skyline Parkway Motel in Afton, Virginia after an arson fire on July 9, 2004. ...


Before purchasing medical insurance, some tend to 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, some tend to be less careful about maintaining their health because they do not have to bear the full financial cost of health care. 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. This description of human behavior implicitly relies on the specification of objectives and the comparison of costs and benefits: if your goal is to maintain your health, then you can compare the benefit of maintaining your health with the cost of paying for health care and the cost of maintaining your health through other means (like spending time to exercise, spending time to become informed about a healthy lifestyle, spending money on healthy food, not smoking, not riding motorcycles, et cetera).


On the other hand, this description of human behavior may not always be accurate when people want to pursue multiple objectives and have limited resources (and have to think about trade-offs). Some may be more careful about maintaining their health if they do not need to pay for health care, when they make decisions by comparing costs and benefits, pursue multiple objectives and have limited resources. For example, an obese person may be more careful about maintaining his weight through weight loss programs or bariatric surgery--as opposed to pursuing other objectives like buying a safe and reliable car or saving money for his kids--if he could have an insurer pay for such procedures, because the perceived benefit of the procedure (relative to the benefit of pursuing other objectives) could outweigh the lowered cost (relative to the cost of pursuing other objectives). If your goals are to spend resources to maintain your health and to provide resources for your kids, then you can compare the benefit of maintaining your health relative to the benefit of providing resources for your kids to the cost of maintaining your health (either by paying for health care or through a healthy lifestyle, whichever is lower) relative to the cost of providing resources for your kids. Of course, this discussion assumes that pursuing both objectives to a greater degree can not be done at the same time, which is only sometimes true. Finally, some may be more careful about maintaining their health when they have an insurer remind them of the importance of doing so if they do not realize the true costs that they must bear from an unhealthy condition. Thus, the insured party may have more information about its actions and intentions than the insurer, but less information about the expected costs and benefits of potential outcomes which result from those actions.


Deductibles, copayment, and coinsurance reduce the risk of moral hazard since the insured have a financial incentive to avoid making a claim. In an insurance policy, the deductible or excess is the portion of any claim that is not covered by the insurance provider. ... A copayment, or copay, is a flat dollar amount paid for a medical service by an insured. ... In the US insurance market, coinsurance is the joint assumption of risk between the insurer and the insured. ...


Moral hazard has been studied by insurers[2] and academics. See works by Kenneth Arrow[3] and Tom Baker.[4] Kenneth Joseph Arrow (born August 23, 1921) is an American economist, joint winner of the Nobel Prize in Economics with John Hicks in 1972, and the youngest person ever to receive this award, at 51. ...


See also

A perverse incentive is a term for an incentive that has the opposite effect of that intended. ... This article or section does not cite any references or sources. ... In economics and political science, free riders are actors who consume more than their fair share of a resource, or shoulder less than a fair share of the costs of its production. ... A conflict of interest is a situation in which someone in a position of trust, such as a lawyer, a politician, or an executive or director of a corporation, has competing professional or personal interests. ... Adverse selection or anti-selection is a term used in economics and insurance. ... It has been suggested that this article or section be merged with Feedback loop. ... The offset hypothesis is the prediction that people respond to improvements in products meant to improve safety by acting less safely. ...

References

  1. ^ http://www.ft.com/cms/s/0/5ffd2606-69e8-11dc-a571-0000779fd2ac.html Lawrence Summers, "Beware moral hazard fundamentalists", Financial Times, September 23, 2007.
  2. ^ Everett Crosby, "Fire Prevention", in Annals of the American Academy of Political and Social Science, Vol 26 Insurance pp224-238, Sept 1905. [1] Crosby was one of the founders of the National Fire Protection Association.[2]
  3. ^ Kenneth Arrow
    • "Uncertainty and the Welfare Economics of Medical Care" (AER, 1963)
    • Aspects of the Theory of Risk Bearing (1965)
    • Essays in the Theory of Risk- Bearing (1971)
  4. ^ Tom Baker, "On the Genealogy of Moral hazard", Texas Law Review, December 1996, 75 Tex. L. Rev. 237

The National Fire Protection Association (established 1896) is an independent, voluntary-membership, nonprofit (tax-exempt) organization. ... Kenneth Joseph Arrow (born August 23, 1921) is an American economist, joint winner of the Nobel Prize in Economics with John Hicks in 1972, and the youngest person ever to receive this award, at 51. ...

External links

  • Discussion of moral hazard and insurance by Robert Schenk
  • Moral hazard and risk
  • The Moral Hazard Myth (in Healthcare)
  • Moral hazard and health care
  • Moral hazard and Bataan Power Plant
  • The Moral Hazard Myth

  Results from FactBites:
 
Moral hazard - Wikipedia, the free encyclopedia (577 words)
In law and economics, moral hazard is the name given to the risk that one party to a contract can change their behaviour to the detriment of the other party once the contract has been concluded.
Because of these hazards, actuaries are careful to avoid insuring any property for more than it is worth, or even for its replacement cost, and almost always require that there be a deductible, an initial up-front sum which the insured must pay out of his or her own pocket.
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.
Moral hazard - encyclopedia article about Moral hazard. (1823 words)
The most well known examples of moral hazard come from insurance Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk of potential financial loss.
Moral hazard also appears in politics Politics is the process and method of making decisions for groups, and any activity aimed at influencing those decisions.
Arguments using moral hazards are used by both supporters and opponents of economic deregulation Deregulation is the process by which governments remove selected regulations on business in order to (in theory) encourage the efficient operation of markets.
  More results at FactBites »

 
 

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