Moral hazard
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In economic theory, the term moral hazard refers to the possibility that the redistribution of risk (such as insurance which transfers risk from the insured to the insurer) changes people's behaviour. For example, a person whose automobile is insured against theft may be less vigilant in locking the vehicle than an individual who is not insured.
The term, which had been used in the insurance industry for many years,[1] was subjected to serious theoretical analysis within economics by Kenneth Arrow in several works from 1963 onwards.[2] Economists generally follow Arrow's use of the term. In a 1996 article Tom Baker explored the history, meanings and controversies concerning moral hazard.[3] Moral hazard is closely related to the concept of information asymmetry, where one party to a transaction has limited access to information that is central to the transaction; in insurance, the asymmetry exists because the insurer's ability to monitor the behaviour or performance of the insured is limited.
However, in the insurance industry itself, a distinction is commonly made nowadays between moral hazard and morale hazard. Under this distinction, the term "moral hazard" is only used in the case of immoral or illegal conduct on the part of the insured party, while changes in behaviour and attitude are called "morale hazard".
The modern insurance industry usage is therefore different from the usage in economic theory, where the notion of moral hazard does not necessarily imply any immoral or illegal conduct.
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[edit] Moral Hazard in Economics
In economics and ethical theory, the term moral hazard may be used for any situation where a person or organization does not bear the full adverse consequences of its actions.
[edit] Lending and Debt
Rescue operations carried out by governments, central banks, or consortiums of financial institutions can encourage risky lending, if lenders know that in case of serious problems they will not have to take losses. Similarly, if governments know that inability to pay creditors will lead to yet more loans (to prop up finances), then they are less likely to have sound financial policies.
Moral hazard can also refer to questionable lending practices by creditors. In the context of international debt, Jubilee USA argues that the IMF and other international creditors create a "moral hazard" when they "lend irresponsibly in the full knowledge that they will not be held accountable for pushing bad loans. Instead, impoverished countries bear all consequences of ill-advised loans and their repayment." [3] The concept of moral hazard is also closely linked with the concept of odious debt.
One example of a moral hazard in lending is the Bataan Nuclear Power Plant in the Philippines:
"A good example of moral hazard is a nuclear power station built by former Philippine president Marcos that was constructed on an earthquake fault line in the province of Bataan in the Philippines. EXIM, a U.S. government backed Export Credit Agency, began negotiations with the Filipino government about a nuclear power plant that would be built by Westinghouse. Westinghouse won the contract by bidding $500 million. EXIM guaranteed the loan, ensuring that no matter the result, Westinghouse would be paid, removing any risk for Westinghouse. The actual project cost was $2.3 billion. Westinghouse was paid even though the plant could never go on-line as it was built on an earthquake fault line. Marcos, a known dictator, received $80 million commission from Westinghouse on the plant that he authorized, but did not pay for. The Filipino people pay this debt at a rate of $170,000 a day in interest and will continue to do so until 2018, even though they have not received even a single watt of energy. This project alone accounts for more than 5% of the country’s total debt." [4]
Note, this example applies equally to EXIM, Westinghouse and Marcos since all parties knew or should have known that the plant would not become operational. The ultimate lender/insurer of this project is the Filipino people.
[edit] Medical insurance
In medical insurance, moral hazard implies that it is possible that an individual would take unnecessary risks or not take steps to ensure their continued health, as the individual would not bear the full cost of subsequent medical care. This argument is controversial, however, as the individual may not bear the full monetary cost of necessary medical care, but clearly bears a substantial non-monetary personal cost. This application of the theory of moral hazard has been used as an argument against universal health insurance due to the potentially higher costs to all insured parties. Opponents of this argument suggest there is insufficient evidence to suggest that individuals would risk their health due to better insurance, and that the potential magnitude of the increased costs is small compared to the costs of other insurance market imperfections, particularly adverse selection.
[edit] Mortgage lending and securitization
In the financial sector, moral hazard has been cited as a potential issue in lending when those with the best knowledge of the risks pass these risks on to third parties, as in the mortgage loan market when securitizing pools of mortgage loans. In the 'traditional' mortgage market, banks and other lenders retained the risk of lending to customers, who were frequently already customers of the same institution. In mortgage securitization, banks 'sell' the loans to investors, and may lose the incentive to maintain the same risk/reward profile and quality standards.[5] This same moral hazard can occur in any lending market where risks are transferred to third parties after origination.
[edit] Deregulation
The term "moral hazard" is sometimes used in the context of economic deregulation. A supporter of deregulation might argue that guaranteed high wages and strictures on employment conditions create worker inefficiency and reduce industrial productivity by entrenching worker benefits regardless of the quality of their work. Conversely, an opponent of deregulation might argue that the removal of price controls will result in a morally hazardous situation where producers of a good collude to raise their prices, thus harming consumers. However, these arguments (and similar ones about welfare and unemployment benefits) are better categorized as being about perverse incentives or unintended consequences, since they do not involve contracts where the contract itself affects behavior.
[edit] Abraham Lincoln and an example of moral hazard
Abraham Lincoln was involved in a court case involving the moral hazard of a 19th-century Illinois law that exempted under-aged debtors from paying their debts. Two youngsters had hired a ploughing team, and, advised by their lawyer, refused to pay. Lawyer Lincoln was engaged on behalf of the ploughing team to have the debt paid. Lincoln conceded the literal meaning of the law, but said that the boys should not be allowed to enter adult life with their names tarnished by a reputation for not paying their debts. Pointing his arm at the opposing lawyer, Lincoln castigated lawyers who prostituted their profession with such advice. The jury found for the ploughing team.[citation needed]
[edit] Moral Hazard in Insurance
In insurance theory, moral hazard is the name given to the increased risk of problematic (immoral) behavior, and thus a negative outcome ("hazard"), because the person who caused the problem doesn't suffer the full (or any) consequences, or may actually benefit. Such a concern typically arises in the context of a contract (for example, an insurance policy). Deductibles, copayment, and coinsurance help reduce the risk of moral hazard since the insured now have a financial incentive to avoid medical care. In economic terms, opportunity and time costs further curb moral hazard issues for insurance firms.
[edit] Examples
The most well-known examples of moral hazard come from insurance. For example:
- Fire insurance increases the incentive to commit arson, especially if someone is operating a failing business and decides that he or she would rather have the cash from the insurance proceeds on the buildings than the buildings themselves. ("Business interruption insurance" may also be based on profitability; after arson, the owner can claim the business was highly profitable.) In a worst-case scenario (from the insurer's viewpoint), the building is over-insured or valuable contents are removed but claims are filed that they were destroyed in the fire.
- In finance, low level of effort by the agent (employee) is called the "moral hazard problem" according to agency theory. The more autonomy the agent enjoys and the greater the information the agent possesses, and the greater the specialised knowledge required to perform the task, the greater the chances for the occurrence of moral hazard (Holmstrom, 1979)
- As a counterexample, studies have shown that because of the specifics of how people utilize health care, Moral Hazard is not a significant value of what is being insured, rather than simply taking the word of the person buying the insurance.[citation needed]
- Requiring that there be a deductible (an initial up-front sum which the insured must pay out of his or her own pocket in case of a loss), and/or only paying out a percentage of the loss (say, 80 or 90 percent) via a coinsurance clause.
[edit] See also
- Perverse incentive, unintended consequence
- Free rider problem, principal-agent problem
- Adverse selection
- Feedback
- Odious debt
- Information asymmetry
[edit] References
- ^ Everett Crosby, "Fire Prevention", in Annals of the American Academy of Political and Social Science, Vol 26 Insurance pp224-238, Sept 1905. [1] Crosby was one of the founders of the National Fire Protection Association.[2]
- ^ Kenneth Arrow
- "Uncertainty and the Welfare Economics of Medical Care" (AER, 1963)
- Aspects of the Theory of Risk Bearing (1965)
- Essays in the Theory of Risk- Bearing (1971)
- ^ Tom Baker, "On the Genealogy of Moral hazard", Texas Law Review, December 1996, 75 Tex. L. Rev. 237
