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Moral Hazard

Moral hazard is concerned with the attitude and behavior of people. Moral hazard refers to deliberate human failing which increases the chance of loss. It is the dishonest instinct in the individual which may impel him to commit fraud or any illegal act. It is largely, the state of working of human mind. For example, a man who insures his vehicle may sell the same vehicle secretly and thereafter, lie to his insurers that the vehicle has been stolen in order to collect indemnity from the insurers. Also, a dishonest business man who insures his stock to another location and turn round to deliberately set the building ablaze in order to collect indemnity from his insurers. Technically, this amount to stealing from the insurer.

Moral hazard unlike physical hazard is very difficult to control since it is the product of the state of working of human mind which cannot be easily controlled.

Moral hazard exists in all branches of insurance and this factor is one of the considerations which insurers take into account when deciding whether or not to provide insurance cover and on the amount of premium to charge. Moral hazard has a general tendency of pushing up premium for both honest and dishonest insured.

An insured may consider it immoral to steal a neighbour’s property, but he may think differently when he decides to steal from an insurance company. Dishonest insured may affect their decisions to steal from their insurers by failing losses or inflating the amount of legitimate claims and justifies their actions on the grounds that the insurers are rich.

This is a completely wrong notion.

However, insurers have been attempting to control moral hazard through skillful underwriting practices and inclusion of certain provisions in the policy, such as excess, franchise, deductibles, exclusions etc.

The Nature of Moral Hazard

A moral hazard is where one party is responsible for the interests of another, but has an incentive to put his or her own interests first: the standard example is a worker with an incentive to shirk on the job. Financial examples include the following:

  •  I might sell you a financial product (e.g., a mortgage) knowing that it is not in your interests to buy it.
  •  I might pay myself excessive bonuses out of funds that I am managing on your behalf; or
  • I might take risks that you then have to bear.

Moral hazards such as these are a pervasive and inevitable feature of the financial system and of the economy more generally. Dealing with them—by which I mean, keeping them under reasonable control—is one of the principal tasks of institutional design. In fact, it is no exaggeration to say that the fundamental institutional structure of the economy—the types of contracts we use, and the ways that firms and markets are organized—has developed to be the way it is in no small part in response to these pervasive moral hazards.


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