Monday, November 22, 2010

Moral Hazard

Moral Hazard is the risk that the presence of a contract will affect on the behavior of one or more parties. The classic example is in the insurance industry, where coverage against a loss might increase the risk-taking behavior of the insured.

The actual words moral hazard have a long history. Using them in the context of financial risk is a return to etymological roots; hazard was originally the name of a dice game, the Middle Ages precursor to craps, on which bets were placed and fortunes could be swiftly lost. For centuries, the resulting use of the word hazard carried a whiff of the unsavory due to its association with gambling.

Moral hazard occurs when a party insulated from risk behaves differently than it would behave if it were fully exposed to the risk.

Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to hold some responsibility for the consequences of those actions. For example, a person with insurance against automobile theft may be less cautious about locking his or her car, because the negative consequences of vehicle theft are (partially) the responsibility of the insurance company.

Information Asymmetry

Economists explain moral hazard as a special case of information asymmetry, a situation in which one party in a transaction has more information than another. In particular, moral hazard may occur if a party that is insulated from risk has more information about its actions and intentions than the party paying for the negative consequences of the risk. More broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.

Moral hazard also arises in a principal-agent problem, where one party, called an agent, acts on behalf of another party, called the principal. The agent usually has more information about his or her actions or intentions than the principal does, because the principal usually cannot completely monitor the agent. The agent may have an incentive to act inappropriately (from the viewpoint of the principal) if the interests of the agent and the principal are not aligned.

According to contract theory, moral hazard results from a situation in which a hidden action occurs. Quoting Bengt Holmström,

'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.'

The name 'moral hazard' comes originally from the insurance industry. Insurance companies worried that protecting their clients from risks (like fire, or car accidents) might encourage those clients to behave in riskier ways (like smoking in bed, or not wearing seat belts). This problem may inefficiently discourage those companies from protecting their clients as much as they would like to be protected.

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