All About Moral Hazard: 3 Examples of Moral Hazard

A moral hazard is an economic term that describes a scenario in a transaction in which one party can indulge in risky behavior because they know that the terms of the agreement will require the other party to assume any negative consequences. The decision to take the risk results from information asymmetry, which occurs when in a transaction, one person or business has more information than the other.

Asymmetric information gives the risk-taking party incentive to take even greater risks, knowing that the other party will absorb them. For example, insured individuals may more willingly take additional risks in their activities because the terms of their life insurance policy or health insurance coverage require the insurer to pay for all or some medical care.

Moral hazard can also apply to scenarios that occur in financial institutions. Central banks—those that oversee currency for a state or union—may be less averse to taking risks because the United States government can cover their losses with a bailout from the US Treasury to keep the economy afloat. Policymakers often cite the 2008 financial crisis, in which banks that the US government considered “too big to fail” collapsed due to aggressive risk-taking, as an example of moral hazard.

It’s important to understand moral hazard because of its impact on both consumers and the economy. The core problem of moral hazard is one of excessive risk-taking. Individuals may feel that they do not need to take precautions because their insurance policies will cover any damages, even if they are still required to pay their deductible or coinsurance. Homeowners may decide to cut back on security measures because of their property and fire insurance, and car insurance holders may take less caution on the roads.

The problem is two-fold: individuals face a greater risk of injury, loss, and even death, and the cost of their risks will only cause their insurance company to increase deductibles and, in turn, the overall price of insurance plans and health care.

Banks and businesses may indulge in moral risk because they believe the US government will give them a safety net if the financial market experiences a crash due to their risk-taking. The result is a win-win for businesses—risk-taking can yield greater profits but is also covered by bailout—but a loss for taxpayers, who foot the bill when these risky investments upend the economy.

Moral hazard exists in many different fields. Here are a few examples:

1. 1. The global financial crisis: The 2007–2008 global financial crisis was a textbook example of moral hazard in banking. Lower interest rates sent borrowers after cheap loans that lenders provided to banks that then sold them to investors. But when the Federal Reserve, or Fed, raised interest rates, the housing market crashed. Homeowners defaulted on their subprime mortgages, sending investors and banks into bankruptcy. The government’s attempt to lessen the damage caused a loss of trillions of dollars from the global economy.
2. 2. Employees in the workplace: Individuals may create moral hazards in job environments. Employees may take less care of office technology like laptops or even incentives like company cars because their employer will pay for them if damaged.
3. 3. Insurance coverage: Insurance coverage can lead to moral hazard when policyholders engage in risky behavior in the belief that insurance companies will foot the bill in the case of injury or property damage.

The concept of moral hazard is closely related to adverse selection, another term used in insurance markets, economics, and risk management to describe scenarios in which one party knows more about a transaction than the other party.

The main difference between the two concepts is the timeframe: A moral hazard happens after the terms of the transaction have been agreed upon, while adverse selection usually occurs before the agreement. These concepts also relate to the principal-agent problem, which occurs when a company representative acts in a way that doesn’t benefit the company’s best interest.

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