What Is Moral Hazard

Moral Hazard is an important phenomena in Economics. It is the idea that individual can alter their behaviour if they know they are insured against some outcomes. The idea of moral hazard has appeared recently with the debate about whether the US government should help to bail out sub prime mortgage lenders. (see end)

Definition of Moral Hazard:

The risk that the presence of a contract will affect on the behavior of one or more parties.

Examples of Moral Hazard

If your bike is not insured you will take great care to avoid it getting stolen. If it becomes insured for its full value then if it gets stolen you do not really lose out. Therefore, you have less incentive to protect against theft. In these cases an insurance firm faces a dilema.

When your bike is uninsured, it has say a 10% chance of getting stolen. Therefore, if the bike is worth £1,000. The cost of insurance would be based around £100.

However, once insured, the bike now have a 30% chance of getting stolen. Therefore, if the insurance firm charges £100 based on the 10% risk it will lose out.

Overcoming Moral Hazard

Build in incentives. The insurance firms needs to provide incentives so that you still want to insure your bike. This is why they will not insure for the full amount. Usually you have to pay the first £50 of an insurance claim. Insurance firms also make the process of getting money difficult? This means that you become more reluctant to make claims and so will try to avoid having your bike stolen in the first place.

Moral hazard and Sub Prime Mortgages

Basically, many sub prime mortgage lenders made reckless lending decisions. They lent mortgages to people who are not really able to pay them back. Now that teaser deals are coming to an end, there is a concern that many sub prime borrowers will not be able to pay so they will default on their payments. This large scale mortgage defaulting could cause many banks to go under and the economy to suffer. Therefore, there is pressure to avoid this situation by keeping people on lower mortgage deals.

However, the problem is that this is effectively rewarding bad economic decisions. If the government bail out reckless lending decisions it may encourage more people to take out reckless loans in the future.

See also:

• Tax on Rubbish