Moral hazard as well as adverse selection are utilized to describe economics in risk-management and insurance to define situations in which one person is at disadvantage because of the actions of another.
Moral danger is when there’s an asymmetrical knowledge among two people, and an alteration in the behaviour of one of them occurs when an agreement between two parties has been reached. Asymmetric information is any circumstance where one of the parties to a transaction has more in-depth knowledge than the other. Moral hazard typically occurs in the insurance and lending industries, however it could be present in employer-employee relationships. If two parties come to an agreement with one the other, moral risks could be present.
Adverse selection is the situation in which sellers have more knowledge than buyers do or vice versa about a specific aspect of product quality, even though the most knowledgeable person will be the vendor. Asymmetric information is used to exploit.
In a moral-hazard circumstance in which one of the parties to the agreement is unable to provide accurate information or alters their behaviour following the signing of the agreement signed because they believe they’ll not face consequences of their conduct. If a person or entity is not able to have to bear the full costs of the risk, they could be enticed to make a greater risk the risk. The decision will be determined by what will bring them the highest amount of benefits.
The chance that one of the parties hasn’t signed an agreement in good faith and could do so by providing inaccurate information regarding their assets and liabilities or credit capacities. This could happen within the financial industry, in the form of contracts between two parties, namely a borrower and a creditor. Moral hazard is also a common occurrence in the insurance business.
An example of Moral Hazard
For instance, let’s say that a homeowner doesn’t have homeowners insurance or flood insurance, but is located in a flood zone. The homeowner is extremely cautious and has an alarm system for their home that assists in preventing burglaries. If there is a storm and flooding, they prepare by clearing out the drains and moving furniture to avoid destruction.
However, the homeowner gets fed up of being concerned about possible burglaries and the need to prepare for floods and so they buy flood insurance and home insurance. Once their home is secured and their home is insured, their behaviour alters. They stop the security system for their home and do not prepare for the possibility of flooding. The insurance company is more at likelihood of being sued by them due to flood-related damage or the damage to property.
A History of Moral Hazard
According to studies done by the economics Allard E. Dembe at The Ohio State University and Leslie I. Boden at Boston University, the term moral hazard was extensively used by insurance companies in England. While the initial use of the term was a reference to fraud and moral conduct, at times, the term “moral” can also be employed to refer to personal behavior in the field of mathematics. Therefore, ethics implications for this term aren’t entirely obvious. Since the 60s, the concept of moral hazards became an area of research in the field of economics. In the 1960s it was not an expression of the moral values of the concerned parties, economists utilized moral hazard to describe inefficiencies that result when risks can’t be understood fully.
The term “adverse selection” is a scenario that one party to the deal has more exact and different information than other party. The party that has less information is in a position of disadvantage to the other party that has more details. This imbalance results in an inefficiency both in terms of price and quantity of services and goods that are offered. The majority of information in an economy is passed via prices, meaning that adverse selection can result from poor price signals.
An example of adverse selection
Consider, for instance, that there are two kinds of people who make up the population which include those who smoke but don’t exercise as well as those who don’t smoke and exercise. It’s a fact that people who smoke and aren’t active have shorter life lives than those who smoke and exercise. Let’s say there are two people seeking to purchase life insurance. One smokes but does not exercise, and another who does not smoke and is active regularly. Insurance companies, with no more information, can’t distinguish between the smoker but doesn’t exercise as well as the other.
The insurance company will ask people to complete questionnaires that allow them to reveal their identity. But, the person who smokes and does not exercise realizes that if they answer truthfully they’ll be charged more insurance costs. They decide to lie and claims they don’t smoke or exercise every day. This results in a negative choice and the life insurance company charges the same price for both people. But insurance is more beneficial to those who do not exercise than to the smoking non-exercising smoker. Smokers who are not exercising will need greater health insurance, and will eventually benefit from a lower cost.
Insurance companies minimize their the risk of large-scale claims by restricting their coverage or increasing their rates. Insurance companies try to reduce the risk of unfavourable selection, by finding groups of individuals who are at greater risk as compared to the general population and charge them higher rates. The job for the life insurance underwriters is to review the applicants for life insurance in order to decide whether or not they should provide them with insurance, or what cost to charge. Underwriters usually evaluate any aspect that might affect the health of an applicant, such as but not only the applicant’s weight, height and family history, medical background and occupation, as well as hobbies, driving record, as well as smoking practices.
Another example of bad selection are the market for used vehicles, where sellers may have more information about the condition of the vehicle and may charge buyers more money than what the vehicle has value. 2 In the case of insurance for autos the applicant could falsely claim an address that has a low rate of crime on their application to get a lower rate even though they live in an area that has the highest rate of car burglaries.
Differentiating Moral Hazard from Negative Selection
Both in moral hazard as well as negative selections, it is evident that there is an information analysis between the two sides. The major difference is how it happens. In a moral-hazard situation where the change in behavior of one of the parties occurs following the time an agreement is signed. In contrast, in an negative selection, there’s insufficient symmetric data prior to when the deal or contract is reached on.