A:

There are a number of ways to reduce moral hazard, including the offering of incentives, policies to prevent immoral behavior and regular monitoring.

Moral hazard, essentially, is risk taking. Generally, moral hazard occurs when one party or individual takes risks knowing that, if the risk doesn't work out, another party or individual then suffers the burden of the consequences related to such behavior. In some instances, moral hazard may occur where the actions taken are a disservice to another once a transaction has taken place.

At the root of moral hazard is unbalanced or asymmetric information. The party taking risks in a transaction has more information about the situation or intentions than does the party that suffers any resulting consequences. Generally, the party with extra information has more motivation, or is more likely, to behave inappropriately in order to benefit from a transaction. The benefit of the asymmetric information often occurs after the transaction has taken place.

Moral hazard occurs in different types of situations and in different arenas. One example is financial bailouts. Lending institutions tend to make their highest returns on loans that are considered risky. They are more inclined to make such loans when they have the assurance or expectation of some sort of government bailout in the event of loan defaults.

For example, mortgage securitization can lead to moral hazard. Originators of mortgages have the ability to pool the mortgages and then portion pieces to investors, thus passing the risk of default on to someone else instead of holding onto it. When an agency purchases the mortgage pool, the risk is passed to it. In such a situation, it benefits the agency to cut down moral hazard by being diligent in monitoring the originators of the loans and by verifying loan quality.

In the health insurance market, when the insured party or individual behaves in such a way that costs are raised for the insurer, moral hazard has occurred. Individuals who no longer incur costs from medical services have an incentive to seek more expensive and even riskier services that they would otherwise not require. For these reasons, health insurance providers generally institute a co-pay and deductibles, which requires individuals to pay for at least part of the services they receive. Such a policy and usage of deductible amounts is an incentive for the insured to cut down on services and to avoid making claims.

Moral hazard in one of its most basic form occurs when employees shirk responsibility at their places of employment. An employee has a basic incentive to do the least amount of work for the same amount of pay. It benefits the employer to cut down on this moral hazard. The employer may establish incentives that encourage employees to accomplish an above-average workload. For example, the offering of bonuses (which may be cash or company stock) for completing a certain number of tasks or for generating more business can serve to steer employees in the direction of desirable behavior and away from undesirable behavior. It also behooves employers to offer long-term benefits designed to motivate employees to be productive and loyal.

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