Moral Hazard – Part 1
Renowned in financial circles for his work on incentives relating to asymmetric information, Professor of Economics at the Massachusetts Institute of Technology (MIT) Bengt Robert Holmström defines the term ‘moral hazard’ in the 1979 Bell Journal of Economics as follows: “It has long been recognized that a problem of moral hazard may arise when individuals engage in risk sharing under conditions such that their privately taken actions affect the probability distribution of the outcome.” Economist Professor Paul Krugman put it in a nutshell by describing moral hazard as being “any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly.”
Moral hazard is closely related to information asymmetry – where one party has superior information, putting the other party at a disadvantage – and can come into play at any time two parties enter into an agreement. The term has had different meanings since first being coined in the 17th century, and despite our modern understanding of the words ‘moral’ and ‘immoral’, does not necessarily refer to the moral standards of parties involved or an intention to defraud, although this is often the case.
Moral hazard was widely used by English insurance companies back in the late 19th century and insurance agreements remain the most common victims of moral hazard today. While insured parties may not set out to deliberately defraud an insurance company, and their actions may not necessarily be looked upon as fraudulent, it is not uncommon for an insured party to behave in a more risky manner, or to be less careful with assets, simply because it becomes the insurance company’s problem should anything go wrong. Why pay for security parking in a dodgy area when the insurance covers vehicle damage or theft? Another example is that of medical insurance, where the insured party may go for the more expensive option purely because they are covered for it. These scenarios are can be countered to an extent by insurance companies by means of co-payments, co-insurance and excess liability which deter frivolous claims and encourage responsible behavior through shifting a measure of financial burden to the insured party. Insurance analysts have coined a related term, morale hazard, referring to the insured party’s indifference to potential loss of assets covered by insurance.
In finance, moral hazard can have an adverse effect on investors, taxpayers, borrowers and depositors, among others. This will be discussed in a follow-up article.