Moral hazard and adverse selection are two terms used in economics, risk management and insurance to describe situations where one party is at a disadvantage. Adverse selection occurs when there's a lack of symmetric information prior to a deal between a buyer and a seller, whereas moral hazard occurs when there is asymmetric information between two parties and change in behavior of one party after a deal is struck.
How Adverse Selection Works
Adverse selection describes an undesired result due to the situation where one party of 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. The asymmetry causes a lack of efficiency in the price and quantity of goods and services. Most information in a market economy is transferred through prices, which means that adverse selection tends to result from ineffective price signals.
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 do exercise. It is common knowledge that those who smoke and don't exercise have shorter life expectancies than those who don't smoke and do 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. However, the insurance company 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 distinguish them. However, the individual that smokes and doesn't exercise knows that answering truthfully means higher insurance premiums, so he lies and says he doesn't smoke and exercises daily. This leads to adverse selection, where the life insurance company is at a disadvantage and then charges the same premium to both individuals. However, the insurance is more valuable to the non-exercising smoker than the exercising non-smoker because one party has more to gain.
How Moral Hazard Occurs
Conversely, moral hazard occurs when a party provides misleading information and changes his behavior when he does not have to face consequences of the risk he takes. For example, assume a homeowner does not have homeowners insurance or flood insurance and 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 buys home and flood insurance. After his house is insured, his behavior changes and he is less attentive, he leaves his doors unlocked, cancels the home security system subscriptioni and does not prepare for floods. In this case, the insurance company is faced with the risks of floods and burglaries and their consequences, and the problem of moral hazard arises.