Moral hazard

In law and economics, moral hazard is the name given to the risk that one party to a contract can change their behaviour to the detriment of the other party once the contract has been concluded. The most well known examples of moral hazard come from insurance. Fire insurance gives people an incentive to commit arson, especially if they are operating a failing business and decide that they'd rather have the cash from the insurance proceeds on the buildings than the buildings themselves. Many, perhaps most, police investigations of arson are the result of leads from suspicious insurance adjusters. More generally, fire insurance may encourage sloppy fire prevention. For example, the expectation that federal government disaster aid will come seems to encourage the residents of Malibu, California, to let bushes and trees grow near their houses, raising the risk of fire. Moral hazard appears in other insurance-related areas as well: automobile insurance makes it safer for people to have accidents that cause injuries or property damage. Because of these hazards, actuaries are careful to avoid insuring any property for more than it is worth, or even for its replacement cost, and almost always require that there be a deductible, an initial up-front sum which the insured must pay out of his or her own pocket. They may also impose conditions, such as the ownership of fire extinguishers (in the case of fire insurance). Moral hazard also appears in politics, for example, as it regards anti-poverty transfer programs and similar programs. The Central Bank's rescue of the creditors of a country suffering from a financial crisis (such as Mexican "Tequila Crisis" of 1994-5) encourages the creditors to make such risky loans again in the future. The existence of unemployment insurance encourages people not to look for work; most such programs thus require that the unemployed prove that they are seeking jobs. Because some people will evade the intent of the rules by submitting sham applications for jobs they are unlikely to get, more bureaucratic restrictions are imposed. It has been argued, especially by political conservatives, that welfare payments to unwed mothers encourage the birth of children born out of wedlock. It could be argued along the same lines that military spending increases the risk of war.

See also

• perverse incentive, unintended consequence\n*free rider, principal-agent problem

External links

• Discussion of moral hazard and insurance by Robert Schenk