Moral Hazard: Meaning, Examples, and How to Manage

What Is Moral Hazard?

Moral hazard is the risk that a party has not entered into a contract in good faith or has provided misleading information about its assets, liabilities, or credit capacity. In addition, moral hazard also may mean a party has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles.

Moral hazards can be present anytime two parties come into agreement with one another. Each party in a contract may have the opportunity to gain from acting contrary to the principles laid out by the agreement.

Anytime a party in an agreement does not have to suffer the potential consequences of a risk, the likelihood of a moral hazard increases.

Understanding Moral Hazard

A moral hazard occurs when one party in a transaction has the opportunity to assume additional risks that negatively affect the other party. The decision is based not on what is considered right but on what provides the highest level of benefit, hence the reference to morality. This can apply to activities within the financial industry, such as with the contract between a borrower and a lender, in addition to the insurance industry.

For example, when a property owner obtains insurance on a property, the contract is based on the idea that the property owner will avoid situations that may damage the property. The moral hazard exists that the property owner, because of the availability of the insurance, may be less inclined to protect the property, since the payment from an insurance company lessens the burden on the property owner in case of a disaster.

Moral hazards can exist in employer-employee relationships as well. If an employee has a company car for which they do not have to pay for repairs or maintenance, the employee might be less likely to be careful and more likely to take risks with the vehicle.

Examples of Moral Hazard

Prior to the financial crisis of 2008, when the housing bubble burst, certain actions on the part of lenders could qualify as moral hazards. For example, a mortgage broker working for an originating lender may have been encouraged through the use of incentives, such as commissions, to originate as many loans as possible regardless of the financial means of the borrower. Since the questionable loans were intended to be sold to investors—shifting the risk away from the lending institution—the mortgage broker and the originating lender experienced financial gains from the increased risk. The burden of the risk would ultimately fall on the investors.

Borrowers who began struggling to make their mortgage payments also experienced moral hazards when determining whether to attempt to meet the financial obligation or walk away from loans that were becoming more difficult to repay.

As property values decreased, borrowers were ending up deeper underwater on their loans. The homes were worth less than the amount owed on the associated mortgages. Some homeowners may have seen this as an incentive to walk away, as their financial burden would be lessened by abandoning a property.

Insurance coverage is also prone to moral hazard. For example, if someone buys the latest cell phone and takes out insurance on it, they may be less likely to be careful with it. The assumption that it will be replaced regardless of their level of care creates a moral hazard. Meanwhile, replacement costs of damaged cell phones then drive up the cost of insurance for everyone who might purchase the coverage.

The Bottom Line

Moral hazards can be a high cost to businesses. Learning how to identify and mitigate them is essential to a business's profitability and longevity. Implementing practices or offering incentives that result in the risk-taking party having some "skin in the game" are means of tackling this problem.