Moral hazard and adverse selection are both used for economics, in risk-management and insurance to explain circumstances where one person is at disadvantage because of the actions of another.
Moral risk is when there’s an imbalance of data in the relationship between two individuals, and changes in the behaviour of one of them occurs following an agreement between the two parties has been reached. Asymmetric information is the situation in which one party to a transaction has more information 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 to an agreement with one with respect to moral hazard, the risk could be present.
The term “adverse selection” refers to an instance where sellers have more knowledge than buyers do and vice versa about a specific aspect of product quality, though typically the person with more knowledge would be the one selling the product. Asymmetric information is used to exploit.
In a moral hazard scenario where one of the parties signing the agreement gives false information or alters their behaviour following the signing of the agreement drawn up because they think they will not be held accountable in the event of their behavior. If an individual or entity is not able to have to bear the full costs of the risk, they could be enticed to take on more risks. This is dependent on what can give them the greatest amount of benefits.
The possibility that one of the parties hasn’t concluded the contract in good faith, and might do this by lying regarding their assets and liabilities or credit capabilities. This is a possibility within the financial industry, 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
For instance, let’s say that a homeowner doesn’t have homeowners insurance or flood insurance, but lives in a flood area. The homeowner is extremely cautious and is enrolled in the home security system which assists in preventing burglaries. If there is a storm and flooding, they prepare by clearing out the drains and shifting furniture to prevent destruction.
However, the homeowner gets exhausted of worrying about the possibility of flooding and burglaries and so they buy flood insurance and home insurance. Once their home is covered and their home is insured, their behaviour shifts. They end their subscription to a home security system and do not prepare for flooding. Insurance companies are now more at chance of getting a claim against them due to the damage caused by flooding or the damage to 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 is widely employed by insurance professionals in England. Although the early use of the term was a reference to fraud and moral conduct, at times, the term “moral” can also be utilized to describe an individual’s behavior within the realm of mathematics. Therefore, moral implications of this word aren’t obvious. Since the 60s, the concept of moral hazards became the subject of a new study in the field of economics. In the 1960s it was not an expression of the moral values of the concerned parties, economists employed moral hazard to describe inefficiencies that result when risks can’t be properly understood.
Abverse selection is a scenario where one party in the deal has more exact and different information than other party. The party who has less information is in a disadvantage to the other party that has more details. This creates an inefficiency with regards to the cost and amount of goods and services offered. The majority of information in an economy is passed along via prices, meaning that any adverse selection could be the result of ineffective price signals.
Ample of Negative Selection
As an example, suppose there are two kinds of people who make up the population which include those who smoke but don’t exercise and those who don’t smoke and exercise. It’s common knowledge that smokers and those who aren’t active have shorter life lifespans as compared to those who do not smoke but choose to 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 who exercises every day. In the insurance industry, with no additional information, is unable to distinguish between the person who smokes but doesn’t exercise as well as the other.
The insurance company requires people to complete questionnaires in order to verify their identity. But, the person who smokes and does not exercise realizes that if they lie about their answers they’ll be charged more insurance costs. The person decides to lie and claims they don’t smoke and exercise regularly. This can lead to a poor choice and the life insurance company will be charging the same amount to both parties. But insurance is more beneficial to those who do not exercise than to the smoking non-exercising smoker. Smokers who do not exercise will need higher health insurance and eventually benefit from a lower cost.
Insurance companies limit their exposure to claims of a large size through limiting their coverage, or increasing their rates. Insurance companies seek to limit the possibility of unfavourable selection, by finding certain groups of people who are at greater risk as compared to the general population and charge them higher rates. The job that underwriters for life insurance underwriters is to review the applicants for life insurance in order in order to determine whether to offer them insurance, or what cost to charge. Underwriters usually evaluate any aspect that might affect the health of an applicant, such as but not just the applicant’s weight, height family history, medical background as well as hobbies, occupation, driving record, as well as smoking practices.
Another example of bad choices include the market for used vehicles, where sellers may have more information about the condition of the vehicle and then charge customers more for the car than the vehicle could be worth. 2 In the case of insurance for autos applicants, they may provide an address that has a low crime rate when submitting an application to receive a lower cost even though they live in an area that has the highest rate of car theft.
Distinguishing Moral Hazard from Negative Selection
Both in moral hazard 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 scenario where the change in behavior of one of the parties occurs after an agreement has been signed. In contrast, in an negative selection, there’s insufficient symmetric information prior to the time that the contract or deal has been reached on.