What is... | October 10, 2011

What is moral hazard?

Does being insulated from risk change the way we behave? Anyone taking out an insurance policy probably thinks they have entered into a straightforward contract. They pay a regular premium in exchange for cover, while the insurer stands ready to pay out as needed.

But is it possible the very act of taking out a policy changes the way each party behaves? Many economists think being insulated from risk leads to different behaviour than being exposed to risk. They have a phrase for it: “moral hazard”.

Hazard lights
Moral hazard says that by insuring ourselves against a costly risk, such as a car crash, burglary, or even very old age, we become more careless in our behaviour. For example, economist Tim Harford writes in his book Undercover Economist that a driver whose policy does not cover theft is more like to pay to park in a guarded compound. Insurers tackle this by using payment excesses, promises to install better locks, and “no claims” rewards to encourage policyholders to share the risk.

Full disclosure
Insurers suffer moral hazard too. If a customer forgets a part of their history (perhaps a small motor incident or a minor ailment), the insurer may find they have taken on more risk than they bargained for. This hazard can be passed on to all insurance customers and law-abiding policyholders may see premiums go up if those unknown risks turn into claims.
Of course failure to disclose full details also exposes claimants and their families to greater risk when the truth emerges.

Financial hazard
The global financial crisis exposed several layers of moral hazard the banking and finance industries around the world. It emerged that some financial institutions underestimated risks associated with certain loans and structured products they were involved in. Some argue this was partly because the institutions believed they were “too big to fail” and governments and central banks would ensure their survival if they ran into severe financial difficulties. In line with the idea of moral hazard, government protection would offer a degree of insulation from risk – leading to different behaviour than if they exposed to risk.
This was a problem not only for large investors and institutions.
Individual investors and savers were also affected. Some argue that government support of the financial institutions encouraged moral hazard among individuals.
People may have taken more risk with their money - for example, not spreading larger deposits across several institutions - because they relied on governments for protection.

Moral high ground
Investors and consumers can try to avoid tricky situations thrown up by moral hazard by taking some simple steps:

  • If an investment offers much higher returns than other similar schemes, ask yourself why. There could be more investment risk than seems obvious at first. Governments and regulators may not bail investors out if they lose money.
  • Similarly, when the price of an insurance policy – perhaps posted on an online site – is much lower than others, read the terms and conditions carefully. There may be special clauses that limit when the policy will pay out.

Phil Thornton
Phil Thornton

Lead consultant at Clariti Economics