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, 澳洲幸运5官方开奖结果体彩网:liabilities, or 澳洲幸运5官方开奖结果体彩网: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 contractꦯ 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 likelihoo🍷d of a moral haz𒅌ard 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 澳洲幸运5官方开奖结果体彩网:insurance industry.

澳洲幸运5官方开奖结果体彩网:For example, when a prope🐓rty 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, ma🌟y 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, th♌e 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 investor🗹s—shifting the risk away from the lending institution—the 澳洲幸运5官方开奖结果体彩网:mortgage broker and the originating lender experienced financial gains from the increased risk. The burden of the risk would ultimately fall on the 澳洲幸运5官方开奖结果体彩网:investors.

ܫ Bailouts of financial companies such as those that occurred during the 2008 financial crisis present another moral hazard. If a firm knows it will be bailed out by the government if it were to fail, it will be incentivized to take excessive risk to chase higher profits while not caring about the damage to the economy or cost to taxpayers.

Insurance coverage is also 🐎prone to moral hazard. For example, ifꦛ 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.