Moral Hazard - Insurance Industry

Insurance Industry

The name comes originally from the insurance industry. Insurance companies worried that protecting their clients from risks (like fire, or car accidents) might encourage those clients to behave in riskier ways (like smoking in bed or not wearing seat belts). This problem may inefficiently discourage those companies from protecting their clients as much as the clients would like to be protected.

Economists argue that this inefficiency results from information asymmetry. If insurance companies could perfectly observe the actions of their clients, they could deny coverage to clients choosing risky actions (like smoking in bed or not wearing seat belts), allowing them to provide thorough protection against risk (fire, accidents) without encouraging risky behavior. However, since insurance companies cannot perfectly observe their clients' actions, they are discouraged from providing the amount of protection that would be provided in a world with perfect information.

Economists distinguish moral hazard from adverse selection, another problem that arises in the insurance industry, which is caused by hidden information rather than by hidden actions.

The same underlying problem of unobservable actions also affects other contexts besides the insurance industry. It also arises in banking and finance: if a financial institution knows it is protected by a lender of last resort, it may make riskier investments than it would in the absence of this protection.

In insurance markets, moral hazard occurs when the behavior of the insured party changes in a way that raises costs for the insurer, since the insured party no longer bears the full costs of that behavior. Because individuals no longer bear the cost of medical services, they have an added incentive to ask for pricier and more elaborate medical service, which would otherwise not be necessary. In these instances, individuals have an incentive to over consume, simply because they no longer bear the full cost of medical services.

Two types of behavior can change. One type is the risky behavior itself, resulting in a before the event moral hazard. In this case, insured parties behave in a more risky manner, resulting in more negative consequences that the insurer must pay for. For example, after purchasing automobile insurance, some may tend to be less careful about locking the automobile or choose to drive more, thereby increasing the risk of theft or an accident for the insurer. After purchasing fire insurance, some may tend to be less careful about preventing fires (say, by smoking in bed or neglecting to replace the batteries in fire alarms).

A second type of behavior that may change is the reaction to the negative consequences of risk, once they have occurred and once insurance is provided to cover their costs. This may be called ex post (after the event) moral hazard. In this case, insured parties do not behave in a more risky manner that results in more negative consequences, but they do ask an insurer to pay for more of the negative consequences from risk as insurance coverage increases. For example, without medical insurance, some may forgo medical treatment due to its costs and simply deal with substandard health. But after medical insurance becomes available, some may ask an insurance provider to pay for the cost of medical treatment that would not have occurred otherwise.

Sometimes moral hazard is so severe it makes insurance policies impossible. Coinsurance, co-payments, and deductibles reduce the risk of moral hazard by increasing the out-of-pocket spending of consumers, which decreases their incentive to consume. Thus, the insured have a financial incentive to avoid making a claim.

Moral hazard has been studied by insurers and academics. See works by Kenneth Arrow, Tom Baker, and John Nyman.

John Nyman suggests that two types of moral hazard exist: efficient and inefficient moral hazard. Efficient moral hazard is the viewpoint that the over consumption of medical care brought forth by insurance does not always produce a welfare loss to society. Rather, individuals attain better health through the increased consumption of medical care, making them more productive and netting an overall benefit to societal welfare. Also, Nyman suggests that individuals purchase insurance to obtain an income transfer when they become ill, as opposed to the traditionalist stance that individuals diversify risk via insurance.

Insurance analysts sometimes distinguish moral hazard from a related concept they call morale hazard.