Glossary term
Moral Hazard
Subject: Risk Management, Risk Fundamentals and Frameworks
Moral hazard arises when protection from loss changes behaviour: a party covered against the downside takes chances, or less care, that it would avoid if it paid for failure itself.
Explanation
The idea began in insurance: a person whose car is fully covered may lock it less carefully. It applies wherever protection weakens the link between a decision and its consequences. A bank that expects the state to rescue it may lend more aggressively, which is the usual worry about institutions seen as too big to fail. Executives paid bonuses on gains but spared the losses can behave in the same way, as can staff whose mistakes carry no penalty. Moral hazard shows up after a deal is made. Its close relative, adverse selection, appears before, when the riskiest people are keenest to buy cover. Practitioners reduce moral hazard with deductibles and co-payments, capital requirements, bonus clawbacks, limits, and resolution regimes under which owners and creditors take losses. Deductibles, bonus clawbacks and bail-in rules all exist because protection that costs the protected party nothing tends to be used carelessly.
Example
A company insures its warehouse with no deductible, so the owner sees no cost if the building is damaged. Spending on fire alarms and maintenance falls over the years. After a large claim, the insurer adds a deductible of 5% of the loss and ties its premium to an annual safety inspection, putting some of the cost back on the owner.
Not to be confused with
- Adverse selection
- Adverse selection happens before a deal, when higher-risk parties are keenest to buy cover; moral hazard happens after, when behaviour changes.