Moral Hazard

Moral hazard has to do with asymmetric information after an agreement has been made, for instance after a contract has been signed. We can continue the insurance example from above in the following way: Say that the careful person has managed to convince the insurance firm that she is, indeed, carful. Therefore, she constitutes a low-risk person, and she only has to pay a small premium to get the insurance. Say that she bought insurance for her bike, and that this guarantees her a new bike if the one she has is stolen. Before she bought insurance, she would have lost the full value of the bike if it had been stolen; now she will only lose the time it takes to get a new one. Consequently, there is much less reason for her to go through the trouble of taking good care of her bike. Therefore, the risk that the bike is stolen increases and she might now constitute a risk for the insurer that is as big as the careless people are. Because she has insurance, her risk behavior has changed to the insurer’s disadvantage. She only had to pay a low price since she is careful, but after she got insurance, she is no longer careful and should have had to pay a high price. Since the insurer cannot check if her risk-behavior has changed, she can take advantage of the firm and offload a larger share of the risk on them than she has paid for.

How to Reduce Problems with Moral Hazard

The classical way to reduce problems with moral hazard in the insurance sector is to demand that the customer keeps a part of the risk. Usually, an insurer demands that the customer pays a certain amount herself, the so-called deductable. Thereby, the risk that she becomes overly careless is reduced.

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