Both moral hazard and adverse selection are used in economics, risk management, and insurance to describe situations where one party is at a disadvantage as a result of another party's behavior.

Moral hazard occurs when there is asymmetric information between two parties and a change in the behavior of one party occurs after an agreement between the two parties is reached. Asymmetric information refers to any situation where one party to a transaction has greater material knowledge than the other party. Moral hazard frequently occurs in the lending and insurance industries, but it can also exist in employee-employer relationships. Any time two parties come into an agreement with each other, moral hazards can be present.

Adverse selection refers to a situation where sellers have more information than buyers have, or vice versa, about some aspect of product quality, although typically the more knowledgeable party is the seller. Adverse selection occurs when asymmetric information is exploited.

Key Takeaways

  • Moral hazard and adverse selection are both terms used in economics, risk management, and insurance to describe situations where one party is at a disadvantage to another.
  • In a moral hazard situation, one party entering into the agreement provides misleading information or changes their behavior after the agreement has been made because they believe that they won't face any consequences for their actions.
  • Moral hazard frequently occurs in the lending and insurance industries, but it can also exist in employee-employer relationships.
  • Adverse selection refers to a situation where sellers have more information than buyers have, or vice versa, about some aspect of product quality.
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Adverse Selection

Moral Hazard

In a moral hazard situation, one party entering into the agreement provides misleading information or changes their behavior after the agreement has been made because they believe that they won't face any consequences for their actions. When a person or an entity does not bear the full cost of a risk, they may have an incentive to increase their exposure to risk. This decision is based on what will provide them with the highest level of benefit.

There is always the risk that one party has not entered into a contract in good faith, and they may do this by providing false information about their assets, liabilities, or credit capacity. This can occur in the financial industry in contracts between a borrower and a lender. Moral hazard is also common in the insurance industry.

Example of Moral Hazard

For example, assume a homeowner does not have homeowner's insurance or flood insurance but lives in a flood zone. The homeowner is very careful and subscribes to a home security system that helps prevent burglaries. When there are storms, he prepares for floods by clearing the drains and moving furniture to prevent damage.

However, the homeowner is tired of always having to worry about potential burglaries and preparing for floods, so he purchases home and flood insurance. After his house is insured, his behavior changes. He cancels his home security system subscription and he does less to prepare for potential flooding. The insurance company is now at a greater risk of having a claim filed against them as the result of damage from flooding or loss of property.

History of Moral Hazard

According to research by economists Allard E. Dembe at The Ohio State University and Leslie I. Boden at Boston University, the term moral hazard was widely used by insurance agents in England. Although early usage of the term implied fraudulent and immoral behavior, at times the word "moral" has also been used to simply refer to subjective behavior in the field of mathematics, so the ethical implications of the term are not clear. In the 1960s, moral hazard became a subject of study again amongst economists. At this time, rather than being a description of the morals of the involved parties, economists used moral hazard to refer to inefficiencies created when risks cannot be fully understood.

Adverse Selection

Adverse selection describes a situation in which one party in a deal has more accurate and different information than the other party. The party with less information is at a disadvantage to the party with more information. This asymmetry causes a lack of efficiency in the price and the number of goods and services provided. Most information in a market economy is transferred through prices, which means that adverse selection tends to result from ineffective price signals.

Example of Adverse Selection

For example, assume there are two sets of people in the population: those who smoke and do not exercise, and those who do not smoke and who exercise. It is common knowledge that those who smoke and don't exercise have shorter life expectancies than those who don't smoke and choose to exercise. Suppose there are two individuals who are looking to buy life insurance, one who smokes and does not exercise, and one who doesn't smoke and exercises daily. The insurance company, without further information, cannot differentiate between the individual who smokes and doesn't exercise and the other person.

The insurance company asks the individuals to fill out questionnaires to identify themselves. However, the individual that smokes and doesn't exercise knows that by answering truthfully, they will incur higher insurance premiums. This individual decides to lie and says he doesn't smoke and exercises daily. This leads to adverse selection; the life insurance company will charge the same premium to both individuals. However, insurance is more valuable to the non-exercising smoker than the exercising non-smoker. The non-exercising smoker will require more health insurance more and will ultimately benefit from the lower premium.

Insurance companies reduce exposure to large claims by limiting their coverage or raising premiums. Insurance companies attempt to mitigate the potential for adverse selection by identifying groups of people who are more at risk than the general population and charging them higher premiums. The role of life insurance underwriters is to assess applicants for life insurance to determine whether or not to give them insurance or how much premiums to charge them. Underwriters typically evaluate any issue that may impact an applicant's health, including but not limited to an applicant’s height, weight, medical history, family history, occupation, hobbies, driving record, and smoking habits.

Other examples of adverse selection include the marketplace for used cars, where the seller may know more about a vehicle's defects and charge the buyer more than the car is worth. In the case of auto insurance, an applicant may falsely use an address in an area with a low crime rate in their application in order to obtain a lower premium when they actually reside in an area with a high rate of car break-ins.

Distinguishing Moral Hazard from Adverse Selection

In both moral hazard and adverse selection, there is information asymmetry between the two parties. The main difference is when it occurs. In a moral hazard situation, the change in the behavior of one party occurs after the agreement has been made. However, in adverse selection, there is a lack of symmetric information prior to when the contract or deal is agreed upon.