Moral hazard occurs in situations in which an economic agent chooses how much risk to take, while the potential negative consequences of these risky choices are (partly) borne by another party. The protection from risk is expected to induce the agent to change behavior—taking on excessive risk or exerting less effort to limit damages—thereby leading to suboptimal economic outcomes. The moral hazard problem arises because the risk-bearing party cannot directly monitor the agent’s behavior. It thus requires that there is asymmetric information concerning the agent’s actions.

Moral hazard in insurance

Insurance coverage is a standard example of a moral hazard situation. By covering the damage in case of negative events like fire, theft, car accidents, or sickness, insurance companies may be concerned that they are unintentionally encouraging their clients to engage in more risky behavior. For example, without dental health insurance, you may take extra time each day to floss and brush your teeth to prevent the cost of dentures and orthodontic treatment. However, if these costs are covered, you may exert less care. While the insurance company cannot observe your daily dental hygiene, it may charge a deductible payment to make you internalize costs and reduce your risky behavior.

Importantly, moral hazard arises from a lack of shared information concerning the agent’s risky behavior. In this, it differs from the problem of adverse selection, which may occur in similar settings when information about the agent is unobservable. For example, a life insurance policy may attract clients with more serious health risks (adverse selection) but may also cause those covered to start engaging in more risky behavior (moral hazard). Similarly, theft insurance may attract clients living in neighborhoods with higher crime rates (adverse selection) but may also cause those covered to put less effort into reducing security risks, for example by leaving their doors unlocked (moral hazard).

Deductibles are a common mechanism to resolve the moral hazard problem in the insurance industry. To illustrate this, consider the following example:

Mr. Smith has bought an expensive racing horse worth 1 million Euro. Installing a gate and door alarm at the horse stable would cost x Euro, but it would reduce the risk of theft of the horse by 5%. How does this affect Mr. Smith’s choices under different scenarios, assuming that Mr. Smith is risk neutral (i.e. Mr. Smith focuses on the expected monetary value of his choice)?

1. No insurance: Without insurance, installing the alarm system pays off for Mr. Smith in expected terms if x < 50,000 (5% of 1 million).

2. Full insurance without co-payment: If the insurance company reimburses the full value of the stolen horse, independent of whether an alarm system had been installed (assume this information is not verifiable by the insurance company), Mr. Smith has no incentive to incur any extra security cost x > 0.

3. Insurance with deductible: If the insurance company decides to charge a deductible of 10%, Mr. Smith incurs a loss of 100,000 Euro (10% of 1 million) in the event the horse gets stolen. Being risk neutral, he would be willing to install the alarm system to reduce the likelihood of this event by 5% if x < 5,000 (5% of 100,000).

In the above example, Mr. Smith is still willing to pay for an alarm when he gets insurance, but less than he would otherwise. As the amount of insurance coverage increases, Mr. Smith’s willingness to pay for an alarm decreases.

Principal-agent problem

Another common example of a moral hazard situation is the principal-agent problem. Here one party (the ‘agent’), who has superior knowledge, acts on behalf of another party (the ‘principal’), who has only limited information and no direct control over the agent’s actions. In this setting, the problem of moral hazard arises when the two parties have a conflict of interest, such that the agent has an incentive to take (unobservable or hidden) actions that are in their own, rather than the principal’s, best interest.

Principal-agent problems commonly occur in situations where there is a separation of ownership and control- for instance, a shareholder (principal) who owns the assets of a business, and their hired manager (agent) who operates the business. The manager will have a higher incentive to pursue the shareholder’s goal of profit maximization if they benefit from the business’s success, for example via a bonus system. However, if the manager benefits from firm profits but cannot be held liable in case of losses, they may have an incentive to take on excessive business risks or reduce their effort on important tasks.

See the following video for a concise explanation of moral hazard and the related asymmetric information and adverse selection topics.

Good to know

Moral hazard played a central role in the events leading up to the 2007-09 financial crisis. Normally, a bank grants a mortgage with the intention of holding it until maturity. It incurs a loss in the event of default and, therefore, has an incentive to carefully screen potential borrowers. However, if a bank generates a mortgage with the plan of selling it afterwards, this incentive to carefully screen borrowers fades. In the time leading up to the financial crisis, mortgage brokers increasingly granted mortgages to home buyers with low credit scores, known as subprime mortgages. The banks then sold these subprime mortgages packaged with standard ones to other banks. The purchasing banks were left with the bad debt when the housing market leveled off and many subprime mortgage borrowers started to default on their payments. This caused a domino effect of major losses across the financial system, and was a major cause of the Great Recession.

Moreover, moral hazard was a central concern regarding potential side effects of interventions taken to ease the crises. The US Federal Reserve Bank stepped in to help some of the largest lending institutions that were on the threshold of bankruptcy during the crisis. When public money is used to bail out private companies that are considered “too big to fail,” this may incentivize those companies to take excessive risks, knowing that they will again be saved by the government in the event of failure in the future.