Moral Hazard: Definition, Meaning, Examples, and How to Manage

What Is a Moral Hazard?

Moral hazard is the risk that a party has not entered into a contract in good faith or has provided misleading information about its assets, liabilities, or credit capacity. In addition, moral hazard also may mean a party has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles. Moral hazards can be present at any time two parties come into agreement with one another. Each party in a contract may have the opportunity to gain from acting contrary to the principles laid out by the agreement.

Any time a party in an agreement does not have to suffer the potential consequences of a risk, the likelihood of a moral hazard increases.

Key Takeaways

  • Moral hazard can exist when a party to a contract can take risks without having to suffer consequences.
  • Moral hazard is common in the lending and insurance industries but also can exist in employee-employer relationships.
  • Leading up to the 2008 financial crisis, the willingness of some homeowners to walk away from a mortgage was a previously unforeseen moral hazard.
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Moral Hazard

Understanding Moral Hazard

A moral hazard occurs when one party in a transaction has the opportunity to assume additional risks that negatively affect the other party. The decision is based not on what is considered right but what provides the highest level of benefit, hence the reference to morality. This can apply to activities within the financial industry, such as with the contract between a borrower or lender, in addition to the insurance industry. For example, when a property owner obtains insurance on a property, the contract is based on the idea that the property owner will avoid situations that may damage the property. The moral hazard exists that the property owner, because of the availability of the insurance, may be less inclined to protect the property, since the payment from an insurance company lessens the burden on the property owner in the case of a disaster.

Moral hazard can exist in employer-employee relationships as well. If an employee has a company car for which he does not have to pay for repairs or maintenance, the employee might be less likely to be careful and more likely to take risks with the vehicle.

When moral hazards in investing lead to financial crises, the demand for stricter government regulations often increases.

Examples of Moral Hazard

Prior to the financial crisis of 2008, when the housing bubble burst, certain actions on the parts of lenders could qualify as moral hazard. For example, a mortgage broker working for an originating lender may have been encouraged through the use of incentives, such as commissions, to originate as many loans as possible regardless of the financial means of the borrower. Since the loans were intended to be sold to investors, shifting the risk away from the lending institution, the mortgage broker and originating lender experienced financial gains from the increased risk while the burden of the aforementioned risk would ultimately fall on the investors.

Borrowers who began struggling to make their mortgage payments also experienced moral hazards when determining whether to attempt to meet the financial obligation or walk away from loans that were becoming more difficult to repay. As property values decreased, borrowers were ending up deeper underwater on their loans. The homes were worth less than the amount owed on the associated mortgages. Some homeowners may have seen this as an incentive to walk away, as their financial burden would be lessened by abandoning a property.

Insurance coverage is also prone to moral hazard. For example, if someone buys the latest cellphone and takes out insurance on it, they may be less likely to be careful with it. The assumption that it will be replaced regardless of their level of care creates a moral hazard. Meanwhile, replacement costs of damaged cellphones then drive up the cost of insurance for everyone that might purchase the coverage.

What Does Moral Hazard Mean?

In economics, the term "moral hazard" refers to a situation where a party lacks the incentive to guard against a financial risk due to being protected from any potential consequences.

How Do You Manage Moral Hazards?

There are a few different ways to minimize moral hazards. The first is to encourage the risk-taking party to act more responsibly by offering them incentives. The second is to institute policies that discourage an immoral behavior by making it a punishable offense. Finally, regular monitoring allows the at-risk party to remain aware of whether or not the other party is taking advantage of them.

What Is Difference Between Moral Hazard and Adverse Selection?

A moral hazard is a phenomenon wherein being protected from the consequences of one's actions encourages additional risk taking. Adverse selection, meanwhile, refers to situations in which one party utilizes information they possess that another party doesn't to ensure a trade is in their favor. As an example, a moral hazard is the risk that an employee who is enrolled in their company's dental insurance plan may be less concerned about their oral hygiene, whereas someone who knowingly has a high-risk lifestyle is making an adverse selection by taking out a life insurance policy.

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