Moral Hazard 101
Imagine there are two parties in the insurance market: the buyer (who is the insured party ) and the seller (who is responsible for providing the insurance coverage ). Moral hazard happens when one party involved in the transaction (typically the buyer) engages in additional, and usually unnecessary, risky behavior because they know that their insurer will cover the costs after their deductible. More often than not, this would negatively affect the other party (typically the seller) in this transaction.
Moral hazard can also happen because of adverse selection. This is when there is an imbalance of information, or asymmetric information. For example, sellers ( insurance companies ) might have more information than buyers ( policyholders ), or vice versa. This can be in regard to the product or its quality. Typically, the seller is more knowledgeable than the buyer. Imagine a seesaw where the weight is tipped more in the seller’s favor. This is called information asymmetry, and adverse selection happens when information asymmetry is taken advantage of.
When applied to moral hazard, insurance companies may allow their policyholders to take additional risks because the companies think they’re covered financially, too. This means that management doesn’t prevent moral hazard from happening because even if it costs the companies more in insurance premiums, they believe that they will receive financial bailouts. The idea behind this is that some companies believe they are too big to fail, and because of this, they will also take more risks in order to get more profits from people buying insurance policies.
This happens because the government provides bailouts to corporate financial institutions, like insurance companies. Taxpayer money creates safety nets so that if something bad happens to the financial market (e.g., a crash, panic, or meltdown), there will be some protection. This tries to keep the market safe from the consequences of a financial crisis, but it also means that the government is involved and may need to exert some control in the market. The government acts as a money lender to insurance companies (the borrowers ), so governments could consider enforcing laws that prevent moral hazard from happening.