Moral Hazard Examples

12 Key excerpts on "Moral Hazard Examples"

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  Moral Hazard

  A Financial, Legal, and Economic Perspective

  • Juan Flores Zendejas, Norbert Gaillard, Rick Michalek, Juan Flores Zendejas, Norbert Gaillard, Rick J. Michalek, Rick Michalek, Juan Flores Zendejas, Norbert Gaillard, Rick J. Michalek(Authors)
  • 2021(Publication Date)
  • Routledge

    (Publisher)

  economists have devoted the most time analyzing the causes and consequences of moral hazard.

  A rapid overview of moral hazard as an issue in the economic literature serves to understand why economists are so concerned. One major reason is the fact that moral hazard may create unnecessary costs to society and lead to distortionary effects. To give but the most illustrative examples of the kinds of moral hazard identified in the literature, we could mention the banking sector, government welfare programs, the automobile industry, and, of course, the insurance sector. Today’s most commonly used theoretical framework underlying the problem of moral hazard is the neoclassical principal-agent theory (Mas-Colell, 1995 ). This theory attempts to describe a situation in which a principal hires an agent to accomplish a task. The principal and the agent have a different set of preferences. More importantly, the agent possesses superior information about the transaction (hidden information). The agent is also in a position where it could take actions that are unobservable to the principal (hidden actions). As a result, the principal cannot verify whether the agent acts according to what was agreed upon in the first place.

  While problems of hidden information are frequently referred to as adverse selection, our view is that moral hazard involves situations of hidden actions.3 Moral hazard reflects the agent’s incentive to engage in [hidden] risky behavior offering a greater reward when it is (or believes it will be) protected from negative consequences, whether through an insurance arrangement or an implicit or explicit guarantee system. It is precisely in the insurance industry where scholars have mostly identified historical narratives on concerns relating to moral hazard. A first example dates back to the 11th century, when the losses that could be insured by a mutual-aid society in feudal France explicitly excluded covering losses that resulted from the negligence of the claimant (Moss, 2004 ). It is not surprising that the design of insurance contracts has been accompanied by endless discussions about the impact on an individual’s disincentive to exercise caution, while increasing the proclivity to engage in careless or risk-seeking behavior (Djelic and Bothello, 2013 , p. 592). Despite these concerns over individuals’ misbehavior, the insurance business has expanded in both the public and the private sectors since the mid-19th century.4

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  New Financial Ethics

  A Normative Approach

  • Aloy Soppe(Author)
  • 2016(Publication Date)
  • Routledge

    (Publisher)

  Moral hazard is a form of opportunistic behaviour in which an agent seeks to strengthen their self-interest at the expense of another party. Usually, moral hazard starts with an information asymmetry in a specific process. Practice shows that moral hazard particularly occurs when a person or group of persons do not bear the full risk of their financial acting. In this case, the risk – partly – belongs to another party through, for example, warranties or other legal positions. When actors themselves do not carry all risk involved in a financial act or process, moral hazard readily arises leading to, for example, individuals or investors taking excessive risks. 2 Examples include banks that are ‘too big to fail’, and are therefore expected to be rescued by the government when things go wrong, such as has happened in financial crises. The same applies to the deposit insurance system for banks. Careful selection of banks becomes less important for customers when the government safeguards them through deposit insurance – see, for example, the European Icesave affair in 2008. Moral hazards readily lead to a paradox. On the one hand (financial), markets need protection and warranties to ensure their effective operation. On the other hand, these safeguards should not exceed a certain threshold otherwise those very warranties create moral hazard that leads to imbalances that may cause a crash. An important manifestation of moral hazard is so-called adverse selection. Adverse selection is the problem where one party has an informational advantage over the other party prior to the transaction. In this situation, rationally acting agents can easily misuse information that the other party does not yet possess. Take, for example, the purchase of a travel insurance policy. Careless people will probably be more inclined to purchase a travel insurance policy than those who are very careful and better protect their belongings when travelling

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  Global Bank Regulation

  Principles and Policies

  • Heidi Mandanis Schooner, Michael W. Taylor(Authors)
  • 2009(Publication Date)
  • Academic Press

    (Publisher)

  Unfortunately, however, all forms of insurance suffer from the problem of moral hazard. The moral hazard is that the insured will allow him or herself to incur greater losses knowing that a third party is footing the bill. To describe this as a form of moral hazard is not necessarily to pass an ethical judgment on this type of behavior. In fact, moral hazard behavior is consistent with economic rationality. It might be more accurate to say that the moral element of moral hazard refers to the element of trust—for example, trust that individuals who seek to insure a particular pattern of behavior will not change that behavior when they get the insurance. The insurer has to have trust that individuals who take out health insurance will continue to lead healthy lives or that individuals with home insurance will take all necessary steps to protect against fires. Despite this trust, moral hazard persists. Car insurance may tempt people to drive more recklessly; fire insurance may tempt people to be less careful in protecting their properties against fire. If bank managers and investors know that the lender of last resort will step in to provide them with liquidity whenever they need it, they will be less concerned over their own risk management than if the bank was forced to rely on the interbank market. Indeed, if the liquidity support is available on terms more favorable than are available in the market, it ceases to be last resort lending altogether and, rather, becomes a form of government subsidy. With regard to deposit insurance, not only are the insureds (depositors) likely to place their deposits with riskier banks knowing that insurance protects their deposit, but deposit insurance may also encourage banks to engage in riskier activities secure in the knowledge that if their risk taking goes wrong they will be bailed out by the government

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  When All Else Fails

  Government as the Ultimate Risk Manager

  • David A. Moss(Author)
  • 2004(Publication Date)
  • Harvard University Press

    (Publisher)

  To combat the preva-lent perception of insurance as a vehicle for evading personal respon-sibility, insurers insisted that moral hazard could be distinguished from other, more natural hazards. They also maintained that it could be screened out altogether. For these insurers, identification of moral haz-ard was a necessary first step toward eliminating it, which was in turn a prerequisite for legitimizing their industry in the eyes of the public. 43 In other contexts, however, practitioners—and especially government policymakers—have viewed moral hazard as an almost inevitable by-product of risk shifting, tempting even the most virtuous of citizens. Whenever someone retains control of an activity after having shed the downside risk (by shifting it to an insurer, for example), he has a strong incentive to try to increase the overall riskiness of the activity. After all, he will reap all the gains, while the other party (the insurer) will have to bear the losses. This is essentially how economists conceive of A Primer on Risk and Its History 37 moral hazard today, though the original sense of moral outrage has been largely abandoned. 44 Back in 1841, when federal lawmakers were debating whether to es-tablish a discharge in bankruptcy (which would erase a bankrupt’s for-mer debts at the end of the legal process), many congressmen worried about moral hazard, though without exactly using the term. One repre-sentative suggested that with a discharge in place, the debtor “was a man above all men exposed and tried. His morals were at stake. By passing such a bill Congress exposed him to such a temptation as ought never voluntarily to be encountered by man .

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  Reactive Risk and Rational Action

  Managing Moral Hazard in Insurance Contracts

  • Carol A. Heimer(Author)
  • 2023(Publication Date)
  • University of California Press

    (Publisher)

  In a malpractice case, for example, the doctor does not suffer the loss, but he or she can be made to share it through legal liability. Stricter liability laws are a legal hazard affecting the probability of loss from an unfavorable de- cision in a malpractice case. Laws and legal interpretations that re- distribute the losses make it more likely that losses not directly expe- rienced by policyholders will later be passed on to them. Moral hazards are "those conditions that increase the frequency or severity of loss because of the attitude and character of an insured person" (Denenberg et al. 1964:8). Many authors use the term moral hazard to describe a tendency toward fraud or, sometimes more mildly, "a departure from the standards of conduct acceptable to society" (Page 1970:64) and use the term morale hazard in dis- cussions of increased carelessness or accident-proneness that may re- sult from insurance coverage. Poor housekeeping, carelessness in surgery, and absentmindedness about locking doors are all examples of morale hazard. Lying or shading the truth when applying for in- surance is an example of moral hazard. Though the distinction is fuzzy, moral hazard is generally taken to be a character trait existing prior to insurance coverage, while morale hazard is a change in in- centives that occurs after coverage. Insurers regard morale hazard as 3 0 R E A C T I V E RISK A N D R A T I O N A L A C T I O N a subtype of moral hazard; economists have devoted their attention exclusively to morale hazard but have called it moral hazard.' Insurers' views of the roles of hazards in modifying the likelihood of insurance losses are summarized in Figure 1. Although the occur- rence of a covered peril such as a fire is assumed to be largely unpre- dictable, some conditions are known to affect the likelihood of such an event. Among these, legal and physical hazards are factors one can calculate about, while moral hazards are not.

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  Facts, Values and Objectivity in Economics

  • José Castro Caldas, Vítor Neves(Authors)
  • 2012(Publication Date)
  • Routledge

    (Publisher)

  This concept arguably poses the most interesting questions for economic discourse. Mainstream economic discourse normally avoids discussions of morals as being outside the purview of economics. Akerlof and Shiller depart from this approach by bringing the moral concept of fairness into the discourse. Nevertheless, they maintain the strict division between rationality and morals. But moral hazard is a concept which is employed in mainstream analysis which focuses on rational behaviour, usually with respect to information asymmetry. It is opportunistic behaviour, i.e. behaviour which takes advantage of an opportunity for personal benefit even if it is at the expense of others. 2 But is it immoral? The ambiguity of moral hazard as a concept arises from the possibility that it can be captured as rational behaviour. As a case study of how moral sentiments are treated in economic theory, we will explore the concept of moral hazard in relation to the financial crisis and show how that affects the nature of the policy response. Concern with moral hazard was central to the way in which the authorities responded initially to the onset of crisis. But first we set out the much broader context of the relation between morals, ethics and economics, exploring how far they can in fact be kept separate. We explore the background to the history of economics as a moral science. There is an extensive literature about (moral) values in economic theory (see e.g. Brennan and Waterman 1994; Peil and van Staveren 2009). Morals can be identified in economics at a variety of levels, but the way in which they appear in economic theory depends on the methodological framework: the closed-system rational-choice framework or any of the open-system political economy frameworks. As a result, the literature has involved a significant amount of talking at cross purposes, not least because of the different meanings attached to terms in the different frameworks

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  The Fear Factor

  What Happens When Fear Grips Wall Street

  • C. Read(Author)
  • 2009(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  They also calculated what would happen if housing prices went up by 10% or even 15%. Frustrated, the CEO asked them what would happen if housing prices went down. They said the model does not include that scenario because housing prices never go down. Within their realm of experience, they were correct. Until 2007, housing prices at the national level rose consistently every year. Incredulous, the CEO asked them why they would propose a plan that, if successful, could earn these young bucks millions of dollars in bonuses, but 10 Moral Hazard 86 The Problems with Risk if it failed, could destroy the company and the investment of thousands of shareholders. Of course, if the firm went bankrupt, all that would happen to the finance whizzes is they’d have to find a new job. This story, in a nutshell, describes the moral hazard problem. When decision makers do not face the brunt of the risk they generate, there is a serious, and sometimes tragic, misconnect. Unfortunately, the term moral hazard has entered the vernacular all too often of late. A term that, until now, was almost entirely confined to discus- sions between economists and policy wonks, it has emerged as one of the most common expressions among financial commentators. Moral hazard and insurance The term was originally coined to describe a special class of problems arising from insurance. In the case of insurance, the mere indemnification of loss can induce some to make decisions that they would not normally make. For instance, those who insure their car for theft are less likely to lock their doors. Or, those with collision insurance may drive with less care than those without. Each of these problems causes concern for insurance providers. The providers are forced to jack up premiums to the pool of insurees who exhibit such adverse behavior. But because the entire pool of insurees bears the brunt of a single insuree’s moral hazard decisions, there is little the insurer can do.

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  Gambling on Humanitarian Intervention

  • Alan Kuperman, Timothy Crawford(Authors)
  • 2014(Publication Date)
  • Taylor & Francis

    (Publisher)

  How the two strands of meaning in these terms carry over to the concept of moral hazard should now be obvious. The first strand comes from the nouns (incentive, precedent), which denote some influence upon the behaviour of actors. The second strand comes from the adjectives (perverse, negative) which indicate that the resulting behaviour is undesirable. That it is undesirable suggests that it is not anticipated, although, as we shall see, this need not always be the case. In the discussion which follows, we will delve deeper into this question of unintended consequences and the role it plays in the moral hazard concept.

  Specifications

  Now we must delineate the essential elements of our concept of moral hazard. The Oxford English Dictionary defines moral hazard as “the lack of incentive to avoid risk where there is protection against its consequences”. If we substitute antonyms for the terms ‘lack’ and ‘avoid’ we come close to the causal-core of the concept—the presence of incentives to take risk where there is protection (or the expectation of protection) against its consequences.

  Where do these incentives come from? Not from thin air, but sooner or later, from the actions of others. Moral hazard is not immaculately conceived: it is fathered by earthly potentates. Moral hazard is thus a ‘relational’ concept which denotes “a relationship of interaction”—more or less direct—between actors (Oppenheim, 1975, p. 287). That relationship involves influence, exercised by those who create moral hazard incentives, over the behaviour of those who respond to them. In this way, the concept of moral hazard forwards a potentially valid causal explanation of the behaviour of political actors exposed to such perverse incentives.

  Thus, for Dane Rowlands and David Carment, the moral hazard of intervention occurs when “the intervener’s own actions cause the combatants to prefer conflict escalation to moderation”. The intervenor’s actions create “incentive structures” which lead the antagonists “to reduce their effort to avoid calamity” (1998, p. 271). Similarly, Robert Rauchhaus has argued that something akin to moral hazard occurs “when a third party, through actions or promises to act, creates an incentive structure that encourages others to take risks or actions that they otherwise would avoid” (Rauchhaus, 2003).5 Thus the impetus for the rebels’ action derives from incentives in their strategic context (created by an inter-venor) rather than from changes in the substance of their goals. That is, intervention or the prospect of it does not transform a contented minority into malcontents, but rather, changes the environment in which, and the means by which, malcontents pursue political change. Moral hazard emboldens malcontents, it does not create them.6

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  Corporate Risk Management

  Theories and Applications

  • Georges Dionne(Author)
  • 2019(Publication Date)
  • Wiley

    (Publisher)

  CHAPTER 10 Optimal Financial Contracts and Incentives under Moral Hazard

  Up to now, we have focused on the analysis of managers' actions that can reduce the dispersion of distributions of random variables.1 These actions, which affect the volatility of results, are called second-order actions because they affect only the moments of distributions greater than one, which are mainly limited to variance.

  The means of distributions are notably affected by risk management actions that introduce first-order variations of distributions (Courbage, Rey, and Treich, 2013; Winter, 2013). They are generally associated with loss prevention, self-protection, precaution, or efforts to obtain higher profits or lower losses. Many of these actions do not involve the use of financial instruments.

  Obviously, entrepreneurs who finance 100% of a project have very strong incentives to maximize the expected profits and to reduce the default probability. In contrast, when a project is financed by third parties with partial guarantees, incentives may be weaker, particularly when the managers' actions are not perfectly observable by creditors. This incentive problem is called ex ante moral hazard. Moral hazard is present when the prevention actions of one party (business, individual, worker, or agent) are not observable by another party associated with the risks of a contract (bank, insurance company, employer, or principal), but may suffer the financial consequences associated with these risks. Moral hazard is often present in debt contracts, insurance contracts, and in the relationship between the board of a company and the officers. Moral hazard was present in securitization activities of banks before and during the financial crisis because banks had no incentives to monitor the credit risk of loans, particularly that of mortgage subprime loans (Dionne and Malekan, 2017; Dionne and Harchaoui, 2008; Malekan and Dionne, 2014; Keys et al, 2009, 2010; Keys, Seru, and Vig, 2012; Bubb and Kaufman, 2014).

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  Microeconomic Foundations II

  Imperfect Competition, Information, and Strategic Interaction

  • David M. Kreps(Author)
  • 2023(Publication Date)
  • Princeton University Press

    (Publisher)

  Hidden action versus moral hazard Economists prefer to avoid value judgments in their professional capacity. 1 Hence, in the economics literature, alternatives to the value-laden term moral hazard are sought. Many economists take the position that Bob, responding in a fashion that is personally optimal for himself given the circumstances in which he finds himself, is not acting immorally. If Bob misbehaves, the fault is Alice’s for not structuring Bob’s incentives properly. (This generally doesn’t extend to breaking the law; and Bob breaking a promise that he gave freely is gray-area behavior.) So, in place of moral hazard, the term hidden action is used: Bob takes actions that are consequential to Alice but are hidden from her. This term doesn’t quite capture the full dimensions of the general issue. There are cases in which Bob’s actions are not hidden from Alice, but still, Bob’s actions are uncontractible : 2 Alice cannot craft a legally enforceable arrangement that prevents 1 A more accurate statement is that they like to pretend that they avoid value judgments. Notwith- standing any such pretense, the fundamental structure of orthodox economics is based on some fairly controversial value judgments. 2 Economists have a penchant for abusing the English language, turning nouns—Alice signed a con- tract with Bob—into verbs—Alice contracted with Bob—and then manufacturing adjectival forms for the new verbs. According to dictionaries, manifolds are contractible, while diseases are contractable, so economists have a choice between “ible” and “able.” I took a quick survey of colleagues: A majority, but not a strong majority, voted for “ible.” Chapter Nineteen. Moral Hazard and Incentives 37 Bob from certain actions, whether she observes them or not. 3 Bottom line: When you see the terms moral hazard and hidden action, they both connote imperfectly the collection of issues and models that are explored in this chapter.

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  Embracing Risk

  The Changing Culture of Insurance and Responsibility

  • Tom Baker, Jonathan Simon, Tom Baker, Jonathan Simon(Authors)
  • 2010(Publication Date)
  • University of Chicago Press

    (Publisher)

  The political mechanisms of insurance ex-pansion I describe call forth moral motives—motives of charity, compas-sion, civic responsibility, and justice. Third, the moral hazard argument is often used to denigrate the value of insurance as a social institution and to limit its development. The argu-ment is a form of conservative, anti-reform, anti-redistributive thinking that economist Albert Hirschman (1991) dubbed “the perversity thesis.” In this form of argument, opponents of a reform claim that although the re-form is intended to ameliorate a social problem, it will in fact make the problem worse. Insurers, of course, promote the social value of insurance, but they too use the idea of moral hazard to justify limits on the amounts and conditions of coverage they offer, the kinds of people and risks they are willing to insure, and the amount of cross-subsidy they build into their pricing (Heimer 1985; Baker 1996). Many economists and policy analysts beyond moral hazard 53 use the concept of moral hazard to argue against broad social provisions of insurance and any kind of assistance to the needy (Epstein 1997a, 1997b). The general lesson of moral hazard, as Tom Baker has shown (1996: 238–40), is “less is more”: less insurance and less social assistance mean more security, welfare, safety, productivity, well-being, and general social good. By contrast, I see the expansionary effect of insurance as a social welfare gain rather than a loss. The social and political dynamic I describe fosters social policies that improve both the well-being of individual citizens and the democratic health of the polity. Insurance is one of the principal mech-anisms by which modern societies define problems as amenable to human agency and collective action. It is not only an institution of repair, but also of social progress, and is a major way for communities to make life better for their individual members.

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  Insurable Interest and the Law

  • Franziska Arnold-Dwyer(Author)
  • 2020(Publication Date)
  • Taylor & Francis

    (Publisher)

  The moral hazard justification for the doctrine of insurable interest derives from the idea that an insured without any interest would stand to benefit from the destruction of, or damage to, the insured subject-matter without any personal loss or detriment which, in turn, might tempt him to bring about its destruction in order to gain the benefit of insurance. This Chapter examines the criticisms of the moral hazard justification drawing on empirical data, doctrinal legal analysis and case studies. In relation to property insurance, it will be argued that the relationship between insurable interest and moral hazard can be better understood if insurable interest is seen as a mechanism for aligning the interests of the insured and the insurer in keeping the insured subject-matter safe. The example of the US STOLI schemes highlights that moral hazard is a real concern in life insurance.

  Historical background and economic analysis

  In Sadlers’ Company v Badcock Lord Hardwicke summarized the moral hazard issue as follows: “…if any person may insure, whether he has property or not, it may be a temptation to burn houses, to receive the benefit of the policy”, and “… the temptation to [destroy ships] has arisen from interest and no interest inserted in policies”.1 Similarly, it was thought that insuring the life of another person in whose life the insured had no interest could lead to the temptation to kill that person.2 From the Preamble of the MIA 1746 it is clear that one of the main mischiefs the Act sought to address was the deliberate destruction of insured ships and cargo by insureds without any interest:

  1 (1743) 2 Atk 554 (Ch) 556.

  2 R Merkin, ‘Gambling by Insurance – A Study of the Life Assurance Act 1774 ’ (1980) 9 Anglo-Am L R 331, 331–333.

  … the making of assurances, interest or no interest, or without further proof of interest than the policy, hath been productive of many pernicious practices, whereby a great number of ships, with their cargoes, have either been fraudulently lost and destroyed …

  (Emphasis added)

  Conversely, by limiting the application of s.1 of the MIA 1746 to British vessels and cargo, Parliament pursued a strategy of encouraging moral hazard in relation to foreign vessels: permitting wager policies on foreign vessels would encourage fraud and aggression against enemy ships as it would make such ships, if insured against capture by British subjects, attractive targets for ‘friendly’ British privateers.3

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