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 risk is when there’s an imbalance of knowledge among two people, and changes in the conduct of one of them occurs when an agreement between two parties has been reached. Asymmetric information is any circumstance where one of the parties in a transaction has more in-depth knowledge than the other. Moral hazard is a common occurrence in the insurance and lending industries, however it could also be present in employment-employer relations. If two parties come into a contract with each with respect to moral hazard, the risk 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 scenario in which one of the parties to the agreement is unable to provide accurate information or alters their behaviour after the agreement is drawn up because they think they will not be held accountable of their conduct. If a person or entity doesn’t have to bear the full costs of an incident, they might be motivated to make a greater risk the risk. This is dependent on what can bring them the highest amount of benefits.
It is always a 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 is a possibility in the financial sector in the form of contracts between the borrower and the lending institution. Moral hazard is also a common occurrence in the insurance business.
An example of Moral Hazard
As an example, suppose that a homeowner doesn’t have homeowners insurance or flood insurance, but lives in a flood area. The homeowner is extremely cautious and has an alarm system for their home that assists in preventing burglaries. If there is a storm that are expected, they prepare for flooding by clearing the drains as well as moving furniture to avoid destruction.
However, the homeowner gets fed up of being concerned about possible flooding and burglaries and therefore, they purchase flood insurance and home insurance. After they have their home secured then their behaviour shifts. They stop their subscription to a home security system and are less likely to prepare for flooding. The insurance company is at greater likelihood of getting a claim against them due to flood-related damage or the destruction of their property.
A History of Moral Hazard
Based on research conducted 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 or immoral conduct, in recent times, the term “moral” is also employed to refer to an individual’s behavior within the realm of math, and ethics implications for this term aren’t entirely obvious. The 1960s saw the beginning of moral hazards became an area of research in the field of economics. In this period instead of being an expression of the moral values of the concerned parties, economists employed moral hazard as a term to describe inefficiencies that result when risks can’t be properly understood.
Abverse selection is a scenario that one party to an agreement has more precise and more specific information than the other party. The party that has less information is in a disadvantage to the one with more details. This imbalance results in an inefficiency both in terms of price and amount of goods and services that are offered. The majority of information in a market economy is passed via prices, meaning that adverse selection can result from poor price signals.
Ample of Negative Selection
As an example, suppose there are two groups of people living in the same population which include those who smoke but don’t exercise as well as people who do not smoke and exercise. It’s a fact that smokers and those who do not exercise have lower life lives than those who smoke and exercise. Let’s say there are two people who want to purchase life insurance. One smokes but does not exercise, and another who does not smoke and is active regularly. Insurance companies, lacking additional information, is unable to distinguish between the smoker and does not exercise, and the other.
The insurance company will ask people to complete questionnaires that allow them to reveal their identity. The person who smokes but doesn’t exercise is aware that if they answer truthfully they’ll be charged greater insurance premiums. They decide to lie and claims they don’t smoke or exercise regularly. This results in a negative choices The life insurance company will be charging the same price for both people. But insurance is more beneficial to those who do not exercise than to the smoker who is exercising. Smokers who do not exercise will need higher health insurance and eventually benefit from a less expensive premium.
Insurance companies limit their exposure to claims of a large size by restricting their coverage or increasing their the cost of insurance. Insurance companies seek to limit the risk of unfavourable selection, by finding groups of individuals who are at greater risk than the general population , and offering them higher rates. The function for the life insurance underwriters is to review potential applicants for life insurance in order to determine whether to offer them insurance, or what cost to charge. Underwriters usually evaluate any aspect that could affect the health of an applicant, which includes but not only the applicant’s weight, height family history, medical background as well as hobbies, occupation, driving record, as well as smoking practices.
Other instances of a bad choices include the market for used cars, in which the seller might know more about the car’s flaws and then charge buyers more money than what the vehicle could be worth. 2 In the case of insurance for autos the applicant could falsely claim an address that has a low crime rate when submitting an application to receive a lower cost even though they live in a region with an extremely high number of car theft.
Distinguishing Moral Hazard from Negative Selection
For both moral hazards as well as the adverse choice, there exists an information analysis between the two groups. The major difference is how it happens. In a moral-hazard situation it is when the change in behaviour of one party takes place following the time an agreement is reached. In contrast, in an negative selection, there’s insufficient symmetric information prior to the time that the deal or contract is reached on.