Understanding Moral Hazard In Insurance

Moral hazard refers to an occurrence where a party who is covered by another party gets involved in a dangerous/risky activity having knowledge that they are covered against the risk and that, the second party will cater for the cost in case the insured risk occurs (Allen et al., 2015). This can also simply be referred to as a change of behaviour that occurs when an individual becomes insured. Originally, insurers perceived moral hazard as unfavourably since it meant that, the insurer paid out more in benefits compared to the expected cost while setting premiums, therefore, resulting in a negative term. However, there are conditions necessary for a moral hazard to occur (Finkelstein, 2014). The first condition is the presence of information asymmetry. This is an occurrence where one party has more information compared to the second party. Another condition is that a contract impacts the behaviour of both parties. Besides, moral hazard results when consumers who are insured are likely to be involved in greater risks with the knowledge that he/she is covered and when the consumer has more knowledge about their intended action compared to the insurers. Studies have revealed that moral hazard is a challenge especially to the insurance market since once insured, individuals/parties are more liable to lose things (Bakx et al., 2015)

For instance, in the health care industry, moral hazard is often perceived as a demand-side occurrence where insurance makes patients use more care due to the reduction in the cost an individual patient has to pay to receive care. This, therefore, means that like in Switzerland, both supply-side and demand-side cost sharing requires to be introduced to alleviate this problem (Bakx et al., 2015). However, studies have indicated that demand-side moral hazard has failed to explain why the per capita health care costs of the United States are much higher compared to other states with lower out-of-pocket charges and universal coverage (Kreier, 2019).

Looking at the impact of moral hazard, it creates a restriction on the consumption-smoothing objective of the insuring company. Insurances are valuable since they ferry the consumption from states having minimal income’s marginal utility -when an individual is healthy to states having increased income’s marginal utility i.e. when an individual is sick. In a normal condition, an insurance contract equalizes the marginal utility across various states. However, the presence of a moral hazard makes it impossible. In a study by Einav & Finkelstein (2018), when a person’s healthcare utilization responds cost of care and the associated health status fails to be contractible, the cost of insurance increase and people becomes unable to pay the break-even price of complete insurance. This is an indication that a balance between maintaining incentives and reducing risk may result in optimal insurance contracts.

Moreover, moral hazard reduces efficiency. When individuals are insured against certain risks, they fail to have an incentive to make efficient processes to minimize the risk of the specified harm. This increases the risk of moral hazard with which investors can take while planning for a project. The investor might fail to adequately assess the externalities created by their project as well as the linked risk which the future governments might redress.

Furthermore, moral hazard reduces the number of insured people an item globally. To solve moral hazard the insurer makes individuals participate in the payment of the costs of risky or hazardous behaviour (Finkelstein, 2014). Therefore, the cost-sharing mechanism has been perceived to discourage people from taking insurance to cover their property hence the number of insured people and property decreasing.

On the other hand, looking at the methods to reduce moral hazard, one of the most proven methods of solving moral hazard is to make individuals participate in the payment of the costs of risky or hazardous behaviour (Hartman-Glaser et al., 2012). For example, in the auto insurance industry, this involves a deductible which forces the owner of the car to pay for some minor damage in full or even pay a large share of the cost of costly damage. This means that, with the owner paying some share, he or she is more likely to be more careful and less the possibility of taking the car in for repairs. Additionally, with the instance more likely to occur in the health insurance industry, similar mechanisms which including sharing of the health care cost reduces the use of medical services excessively hence moral hazards are avoided.

Looking at the financial industry, the mechanism of reducing and avoiding moral hazard though varies from the first mechanism, it uses a similar principle (Rowell & Connelly, 2012). This mechanism involves making sure that people who make decisions about how to invest other individual’s money face consequences once they make bad investments. This strategy is simply penalizing bad behaviours. For instance, if a government bailout a bank, it may choose to penalize the management who were responsible for making reckless decisions. For instance, studies reveal that in Greece, bailout funds are offered with reluctance in addition to conditions to pursue austerity and reform (Bini Smaghi, 2013). However, other studies by White (2008) repute this mechanism and suggest that, the best alternative for this mechanism if creating a moral hazard is to let organizations fail especially where the associated risk is too big and letting stronger organizations/corporations to buy up the wreckage. In a truly free market, the corporation often fails whether they're insured or not though the impact is minimized. Therefore, the thought of a company being overtaken by another company is enough to prompt serious second thoughts.

The third option to reduce moral hazard is to Split up an organization to ensure that, they are not too big to fail. Studies indicate that the idea of an organization being too big to fail is one of the moral hazards (Schwarcz, 2017). In this case, if the management of an organization and the public believe a firm will receive a huge financial bailout to revive it, the management can take increased risks in pursuit of profit. This bailout creates moral hazards that result in increased risk-taking-meltdown, which reinforces the need for increased government regulation.

In conclusion, moral hazard refers to an occurrence where a party who is covered by another party gets involved in a dangerous/risky activity having knowledge that they are covered against the risk and that, the second party will cater for the cost in case the insured risk occurs. This impact the efficiency of an organization, decrease people willingness to be insured and it creates a restriction on the consumption-smoothing objective of the insuring company. This moral hazard can be reduced by cost sharing, inducing consequences to decision makers and splitting an organization.

References

• Allen, F., Carletti, E., Goldstein, I. and Leonello, A., 2015. Moral hazard and government guarantee in the banking industry. Journal of Financial Regulation, 1(1), pp.30-50.
• Bakx, P., Chernichovsky, D., Paolucci, F., Schokkaert, E., Trottmann, M., Wasem, J. and Schut, F., 2015. Demand-side strategies to deal with moral hazard in public insurance for long-term care. Journal of health services research & policy, 20(3), pp.170-176.
• Bini Smaghi, L., 2013. Austerity: European democracies against the wall. CEPS Paperbacks. July 2013.
• Einav, L. and Finkelstein, A., 2018. Moral hazard in health insurance: What we know and how we know it. Journal of the European Economic Association, 16(4), pp.957-982.
• Finkelstein, A., 2014. Moral hazard in health insurance. Columbia University Press.
• Hartman-Glaser, B., Piskorski, T. and Tchistyi, A., 2012. Optimal securitization with moral hazard. Journal of Financial Economics, 104(1), pp.186-202.
• Kreier, R., 2019. Moral Hazard: It’s the Supply Side, Stupid! World Affairs, 182(2), pp.205-223.
• Rowell, D. and Connelly, L.B., 2012. A history of the term “moral hazard”. Journal of Risk and Insurance, 79(4), pp.1051-1075.
• Schwarcz, S.L., 2017. Too big to fool: Moral hazard, bailouts, and corporate responsibility. Minn. L. Rev., 102, p.761.
• White, L.H., 2008. How did we get into this financial mess? (p. 110). Cato Institute.