Moral Hazard

Moral hazard is a term that was first used in the banking and insurance industries in the 18th century, and reintroduced into the economics of risk by Kenneth Arrow in the 1960s. Moral hazard occurs in cases where the very act of making some contract changes the behavior of one of the contractors in a manner that is against the interests of the other contractor. Thus, within insurance markets, the very act of taking out property insurance means that the insured party will not act as carefully with regard to one's property as one otherwise would have; or, if one has insured against ill health or accident, one might take riskier actions knowing one is covered. With no home insurance, one might buy extra strong locks for windows and doors; once the contents are insured against burglary, one might save money on the locks. Thus, in the classic moral hazard account the contract changes the nature of the behavior of the agent.

In Arrow's original health market case, the moral hazard issue is particularly potent: the patient and the doctor both have an interest in the provision of a greater amount of health care at any given level of patient illness, because it is the insurance company that will pick up the bill. For example, if the doctor offers two remedies, one very cheap and likely to cure the problem, the other very expensive but only slightly more likely to work, then patients who have to pay the bill themselves might choose the cheaper, almost-as-good option. However, if the insurance company is paying the bill, they will choose the slightly better option no matter how much more expensive it is. Of course, the doctor and hospital would prefer to sell the most expensive treatment. The patient and the doctor are in a latent conspiracy against the insurance company.

Similarly with property insurance: if some item is damaged and the and householders themselves are paying, they would rather repair the damaged item at a lower cost than fork out for a new one. Or they might accept that the damage is minor and not have the item repaired at all. However, if the insurance company is paying, householders can conspire

In order to overcome moral hazard, insurance companies demand that patients pay a fixed portion [Page 426]of the cost of treatment, insist on specified traders providing services, require several quotes, or send their own assessors out to assess damage.

Moral hazard thus involves a power relationship concerning asymmetric information between those with information and those without. It is part of the general principal-agent problem and closely related to adverse selection. However, it is a mistake to think that any action taken by an agent that is unseen by a principal constitutes a moral hazard issue, or else it becomes difficult to distinguish moral hazard from adverse selection. Adverse selection might also involve unseen action, because agents who act against their principals' interests when they are not being watched are simply displaying the adverse dispositional characteristics the principals wanted to avoid when appointing them. Furthermore, in Arrow's sense, moral hazard can occur where the population is homogeneous but the act of making a contract has itself created perverse incentives. Adverse selection, on the other hand, requires a heterogeneous population.

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