Moral hazard

Origins of the term

Moral hazard is a term originally used in the insurance industry to explain why, when insured, individuals might act more recklessly than when they are not insured.

In the shipping industry, purchasing insurance means that the risks associated with owning and operating the vessel are transferred to the insurer. The calculation of the price (or premium) factors-in the likely cost associated with any damage, plus a profit margin. Damage to the ship, or total loss of the ship, and its cargo, will result in a claim against the insurance policy, and a payout.

However, it is possible that, over time, the insurance payout value becomes greater than the value of the assets - the ship and any cargo. This means that there is less incentive to maintain the ship to the necessary standard, and less incentive to act 'carefully' when operating the ship. If the risks had not been transferred to an insurance company in the first place the ship and its assets would have been better maintained and operated.

At the time of signing the original insurance contract the principal (the insurer) does not know how the insured (the agent) will behave - knowledge is asymmetric, and the insurer must trust the insured to act reasonably and responsibly.

In the insurance industry, moral hazard is taken into account when underwriting many types of risk, but the extent of moral hazard cannot be known in advance. More widely, moral hazard can occur in any situation where normal incentives to behave appropriately are absent.

Examples of moral hazard

In addition to moral hazard in shipping, there are numerous cases where moral hazard may be present, including:

Motoring

For example, being insured to drive a car might make drivers less cautious when driving given that they know that, in the event of an accident, the insurance company will pay for the damages.

Healthcare

For example, the provision of healthcare free at the point of need (real or perceived) may affect the decisions by individuals regarding their own health. Knowing that treatments are available for alcoholism some individuals might be encouraged to drink excessively and beyond the level that they might do if no treatments were available through state healthcare provision.

Welfare benefits

The concept of moral hazard is also widely used in economics to assess the effect of the state provision of services, benefits, and bail-outs, including healthcare, welfare payments, and bail-outs in the financial sector.

The provision of welfare benefits might lead individuals either not to look for work, or to leave a job without a suitable alternative job given that, at least at a basic level, the state will provide for them for a period of time.

Bank failures

Many have argued that the numerous bank failures associated with the ‘financial crash’ were, at least, partly the result of moral hazard in the banking sector.

Given that bank employees may have thought that banks were ‘too big to fail’ some may have carried on their high-risk lending and investment activities assuming the state would ‘come to the rescue’.

Loans and debt dependence

It is also possible that countries can experience widespread moral hazard when they rely on loans from organisations like the International Monetary Fund. Debts might be refinanced or written off if debtor countries cannot repay. However, knowing this means that any incentive to repay debts will diminish, and this may trap countries into long term debt dependence.

Remedies for moral hazard

While the impact of moral hazard is difficult to quantify, and hence difficult to prove, it is used widely in economics in terms of evaluating a whole range of economic policies and behaviours.

Given that the fundamental cause of moral hazard relates to asymmetrical information and lack of incentives it would seem that the most effective remedies will involve closing information gaps and introducing incentives to act responsibly. Each case is likely to require unique responses, but general remedies might include:

Forcing disclosure

Individuals or organisations with inadequate information (such as motor insurers, or those providing credit) could force full disclosure of relevant information so that risks can be fully assessed, and policies or contracts adjusted to include any changes in risk as a result of disclosure.

Cigarette companies may be compelled to reveal all they know regarding the health effects of smoking, and provide this information prior to purchasing - in most countries it is compulsory to label cigarette packs with health information.

Financial providers could be forced to be more transparent in their dealing with customers, such as fully explaining the consequences of defaulting on loans. Financial services providers could also be forced to 'unbundle' their financial products so that customers can more fully understand the various elements involved in a financial product. One reason for the financial crash (2007-2009) was that financial products were bundled together, and often given a new name so that purchasers were unaware of aspects of these products, such as who had a 'call' on repayments. Mortgages were repackaged and sold on to other companies without the prior knowledge of the borrower or, often, without the knowledge of the salesperson.

Introducing penalties for non-disclosure of relevant information.

Increased training for those involved in selling complex financial products.

More screening of applicants [for insurance, for jobs, for complex financial products].

Increased monitoring of behaviour following a transaction.

Setting and agreeing professional standards and codes of conduct relating to specific industries where asymmetric information is common, such as with garage repairs, medical treatments, complex financial products, and property sales.

Providing incentives

Incentives could be developed to encourage efficiency and cost control - especially relevant in the insurance industry.

Offering no-claims bonuses and requesting that those insured contribute to the cost of any repairs (called an 'excess' charge) - such as is common in motor insurance.

Structural adjustment programmes (SAPS) required by international organisations, including the IMF, which lay down specific conditions that must be met by borrower countries, such as having a stable financial system, tight control of public spending, control of corruption, and regular reporting back.


Externalities

Why are externalities a market failure?

Externalities
Information failure

What is asymmetric knowledge?

Information failure
Welfare

How does equilibrium create welfare?

Welfare

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