Moral hazard
In economics, a Moral hazard is a situation where an economic actor has an incentive to increase its exposure to risk because it will not bear the full costs associated with that risk. For example, when a corporation is insured, it may take on higher risk knowing that its insurance will pay the associated costs. A moral hazard may occur where the actions of the risk-taking party change to the detriment of the cost-bearing party after a financial transaction has taken place.
Moral hazard can occur under a type of information asymmetry where the risk-taking party to a transaction knows more about its intentions than the party paying the consequences of the risk and has a tendency or incentive to take on too much risk from the perspective of the party with less information. One example is a principal–agent approach (also called agency theory), where one party, called an agent, acts on behalf of another party, called the principal. However, a principal–agent problem can occur when there is a conflict of interest between the agent and principal. If the agent has more information about their actions or intentions than the principal then the agent may have an incentive to act too riskily (from the viewpoint of the principal) if the interests of the agent and the principal are not aligned.
Moral hazard is the increased risk-taking behavior that occurs when one party is insulated from the negative consequences of their actions, because another party will bear the cost. This often happens when someone has insurance and takes fewer precautions than they normally would, such as a homeowner not locking their doors or a driver being less careful on the road because they know the insurance will cover any losses. The term can also apply in finance, where banks may take on more risk if they believe the government will bail them out.
In insurance: Someone with car insurance might drive more recklessly, or a business owner with fire insurance might be less diligent about fire safety. This happens because the insured party doesn’t have to bear the full cost of potential damages, leading to a higher probability of loss for the insurer.
In finance: A company might take on excessively risky investments if it believes that the government will provide a bailout to prevent systemic collapse. This can lead to a situation where the company benefits from high profits, but taxpayers bear the cost if the risky investments fail.
Root cause: The problem stems from asymmetric or unbalanced information, where the party taking the risk has more information about their actions or intentions than the party that will suffer the consequences.
Mitigation: Ways to reduce moral hazard include:
Implementing deductibles, co-payments, and other policies to ensure the insured still has some financial stake in the outcome.
Increasing monitoring and oversight of behavior.