CFA, Finance, FRM

What is Moral Hazard Risk?

Definition of Moral Hazard Risk : 

  • Moral Hazard is a danger that insuring against risk will make the event one is trying to insure, more likely to occur.
  • It can also be defined as the situation in which one party engages in risky behavior or fails to act in good faith due to the fact that the event is insured against by the actor and the person acting does not bear the economic consequences of his/her behavior.
  • Anytime a party does not have to bear the potential economic consequences of a risk, the likelihood of moral hazard increases, and thereby the chances of the event taking place increases.

Example:

Imagine a house owner named Billy who has no fire insurance on his property. Billy likes to be very cautious about anything and everything that can cause the fire to break out. He calls the electrician once a month to check up on the wiring, refuses to keep a very minimal amount of flammable liquids in his house, and always keeps a fire extinguisher in place just in case. He does this not because it’s fun, but primarily because he knows that he doesn’t have any fire insurance and if in case a fire breaks out and his house burns down, he’ll have no place to live and the entire value of his house would be a loss for him.

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Juxtapose the previous case with another house owner named Karen. Unlike Billy, Karen has fire insurance on her property and knows that if in case something bad happens, the fire insurance company will take care of it and she’d bear no loss. Karen doesn’t call the electrician, keeps flammable liquids in her house, and doesn’t keep a fire extinguisher in her house just in case because she doesn’t bear all the economic consequences of a fire breaking out. The existence of insurance has made it much more likely for the fire to break out and burn the house down because of the negligence and ignorance of Karen.

Hence, the idea of Moral Hazard Risk has connotations to the fact that we as people are much more likely to indulge in risky behavior knowing that we don’t bear the consequences of it at all or partly bear them along with some other party.

Origin of, and the usage of the word ‘Moral Hazard’

Though primarily used in the Insurance domain, the word can be used to discuss employee-employer situations and also in the Economics and Finance world as a whole.

There are two main contractual based elements that lead to Moral Hazard:

  1. Asymmetry of information by two-party involved in the contract: This means that either of the two parties involved in the contract has more relevant information available to them than the counterparty. This allows the party in control of the higher information who may also have the motivation to conduct activities that would be deemed inappropriate to benefit from a transaction at the cost of other parties involved.
  2. The contract has effects on two different entities’ behavior: It’s most likely that the parties have differing incentives in a contract. For example, in an insurance contract scenario, the insurer has an incentive to lower the damage, while on the other hand, the insured does not, so he/she will take on higher risk.

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Example from Business World:

In the business world, the appearance of Moral Hazard is quite common. As at any time where a person does not have to suffer the full consequences of an accident, moral hazard can occur.

  • Governments may take the decision for a corporate bailout, which means that the government will in part bear the negative economic consequences of the business taking an excessively risky business activity. And as the government shoulders such a burden, the businesses will engage in risky activities that they would never have otherwise.
  • Studies have shown that when the employer pays remuneration for an employee in the starting of the month, the employee has an incentive to put forth less effort, take longer breaks, and only perform up to the minimum standards. Due to this, in the majority of the workplaces, the remuneration is paid at the month-end.
  • A number of lessons can be learned from the 2008 financial crisis. One of the things we failed to predict was the lack of hesitation with which the homeowners left their mortgage. Secondly, there was also a moral hazard on part of mortgage brokers who were commissioned and encouraged the banks to focus on creating as many loans as they could, this led to the brokers being ignorant and not checking for borrower’s ability to pay back the loans.

Solutions to the Moral Hazard Problem

As discussed before, the root problem is the existence of asymmetrical information and a contract that alters the behavior of the parties involved. The solution to Moral Hazard lie around understanding these two roots.

  1. In Insurance: The insurance firms may design a contract in such a way that it incentivizes you to insure the bike. They usually won’t insure the full amount and may also make the process of getting back the amount very difficult.
  2. Bail-outs and Investment: Penalize and keep a check on the behavior of the party being bailed out. It’s also a common practice to limit the use of the funds provided.
  3. Employer-Employee: Performance-related pay can act as a motivation, performance evaluation, and lack of job guarantee for keeping the employees on their toes.

About the Author: Aman is an Economics and Finance graduate with a budding interest in Strategic Management and Investment. An avid reader of all things Behavioral and Data Science –I strongly believe in solving problems with solutions backed up by quantitative rigor.

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