moral hazard

(noun)

The prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk.

Related Terms

Examples of moral hazard in the following topics:

  • Chapter Questions

    • Identify examples of moral hazard and adverse selection for a person buying car insurance.

  • Answers to Chapter 5 Questions

    • Moral hazard is a driver become more careless, like leaving his keys in the car.

  • Managers, Shareholders, and Bondholders

    • Moral hazard and conflict of interest may arise.

  • Defining Agency Conflicts

    • Moral hazard and conflict of interest (COI) may thus arise .

  • Contractual Saving

    • Insurance companies use the law of large numbers as they insure a large number of people.On average, statisticians can predict an insurance company's pay out in claims because they, on average, accurately predict the rates of death, illness, injury, and property damage for an entire country.Statisticians do not know which specific individuals will experience hardship, but they can predict how often it occurs.Unfortunately, insurance companies have two problems, when selling insurance policies: Adverse selection and moral hazard.Adverse selection means a person buying insurance has more information than the insurance company.For example, a person knows he has a heart problem and decides to buy a very large life insurance policy, and he hides this information.Moral hazard means people buying insurance becomes more careless than when they did not have insurance.For instance, a person buys theft insurance for his home,and this person stops locking his windows and doors when he leaves, increasing the risk a burglar will break into his home.
    • Insurance companies use two strategies to combat moral hazard and adverse selection.First, insurance companies gather information about the policyholders, such as driving records, medical records, and credit histories.Consequently, the insurance company charges a higher premium to a person who is likely to file a claim, which we call a risk-based premium.Second, insurance companies use a deductible.When a person makes a claim, the person must pay the first portion.For example, a person buys health insurance with a $500 deductible.After this person has paid the first $500 to a doctor, then the insurance company pays the remainder of the claim.This passes some of the responsibility to the person holding the insurance policy.Finally, a person could buy insurance with smaller premiums but with a greater deductible.

  • Government Financial Institutions

    • Some people question a government's role in financing.When a government directly lends, the government squeezes the financial institutions out of the loan market.Furthermore, the federal government loan guarantees increase the problem of moral hazard.Financial institutions receiving the loan guarantees might not screen borrowers as much, lending to borrowers with a high default risk.For example, the effects of the 2007 Great Recession continue to linger in the U.S. economy, even in 2014.Recession caused mass layoffs and doubled the unemployment rate.Then the housing values continue to plummet while foreclosures continue soaring.Consequently, the U.S. government might be liable for trillions of dollars in loan guarantees and bailout of public corporations.We explain several examples below:

  • Debt

    • Debt usually refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.

  • Discount Policy

    • Third, the Fed uses moral suasion, which means the Fed uses its power to persuade depository institutions to do what the Fed wants.