Moral Hazard

Moral Hazard
Moral Hazard
• Moral hazard refers to the reduced incentive
to exercise care once you buy insurance.
• Example: Once I buy a car insurance that pays
100% of loss, I will exercise less caution as to
where I leave my car
• Note that this is a behavior observed AFTER
insurance buying
Moral Hazard
• Caution: Moral hazard can look very similar to
adverse selection—both arise from
information asymmetry.
• Adverse selection arises BEFORE the insurance
is bought
• Adverse selection arises from hidden
information about the type of individual
you’re dealing with; moral hazard arises from
hidden actions.
General problem: Monitoring behavior
• Car insurance companies usually cannot watch
drivers if they are driving too fast or too long –
both can increase the chance of an accident
• In 2004, the Progressive Direct Group of
Insurance Companies introduced TripSense – a
service that provided a free device to record
mileage, speeds and times driven in a vehicle.
Moral Hazard
• Progressive then used this information to offer
discounted renewal policies to customers who
drove fewer miles at slower speeds during
non-peak hours.
• This helps the insurance company solve two
problems. Adverse selection, and moral
Moral Hazard
• The decision of how frequently, how far, or how
fast to drive is equivalent to choosing your
probability of having an accident.
• The cost of having an accident goes down when
you buy insurance.
• Once you have insurance, the cost of an accident
is reduced, which also reduces the cost of the
risky behavior.
• This is the problem of “moral hazard” and exists
in many contexts, not just in the market for
Moral Hazard
• Moral hazard and adverse selection are closely
related problems.
• Both are caused by information asymmetry:
moral hazard results from hidden actions;
while adverse selection results from hidden
• The cost of managing both problems can be
reduced by reducing uncertainty (gathering
more information).
Moral Hazard
• Suppose that bike owners stand a 40% chance
of theft when parking their bike on the street
• Suppose the cost of bike $1000
• Actuarially fair premium would be $400
• However, if the bike owner exercises care
(locks the bike), the chance of theft is reduced
to 30%.
Moral Hazard
• Suppose the cost of taking care (buying a lock)
is $50.
• For uninsured bike owners, the benefit of
exercising care is (0.40 - 0.30)($1000) = $100
and is greater than the costs of exercising
care, $50.
• Moral hazard suggests that once customers
purchase insurance, they exercise less care
because there is less incentive to do so.
Moral Hazard
• The cost of bike theft is reduced when an
insurance policy is purchased.
• So, the consumer stops taking the extra time
to lock up the bicycle every night once she
buys insurance.
• The probability of theft then increases from
30% back to 40%.
Moral Hazard
• The insurance company anticipates this moral
hazard, and now charges $400 for every policy it
• If the company does NOT anticipate that the
probability of theft will increase from 30% to
40%, it will lose money on the insurance it sells.
• In other words, insurance companies need to
anticipate moral hazard and protect itself against
• Give a moral hazard and an adverse selection
explanation for each the following:
• Drivers with air bags are more likely to get into
traffic accidents.
• Volvo drivers are more likely to run stop signs.
• At all-you-can-eat restaurants, customers eat
more food.
• Air Bags: The adverse selection explanation is
that bad drivers are more likely to purchase cars
with airbags. If you know you are likely to get
into an accident, it makes sense to purchase a car
with airbags. The moral hazard explanation is
that once drivers have the protection of airbags,
they take more risks and get into more accidents.
If you don’t believe that people change behavior
in this way run a simple experiment – next time
you drive somewhere, do not wear a seat belt.
See if you drive more carefully.
• Volvo Drivers: Adverse selection – people who
are more likely to run stop signs will want to buy
safer cars, so they will be more likely to buy
Volvos. Moral hazard – once you own a Volvo,
you feel safer so you will be more likely to run a
stop sign
• Restaurant: Adverse selection – attracts people
who are more likely to be big eaters. Moral
hazard – once you have paid for all you can eat,
you are more likely to eat more.
Key differences between moral hazard
and adverse selection
• Adverse Selection:
• 1. Before transaction occurs
• 2. Potential buyer of insurance most likely to
produce adverse outcomes are ones most likely
to seek insurance and be selected
• Moral Hazard:
• 1. After transaction occurs
• 2. Hazard that buyer of insurance has incentives
to engage in undesirable activities making it more
likely that the bad outcome would occur

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