The Hidden Dangers of Moral Hazard in Insurance

What is Moral Hazard in Insurance?

Moral hazard refers to the tendency for insurance to change incentives and encourage more risky behavior. Specifically, it occurs when people engage in riskier activities because insurance reduces the financial cost of those activities.

The Risks of Moral Hazard in Insurance

Information asymmetry plays a key role in moral hazard. Once insured, people have more information on their own behavior, while the insurer lacks that same visibility. This lack of transparency allows for risky behavior that can increase claims.

Moral hazard involves a calculated cost-benefit analysis. An insured party may take on more risk knowing that insurance will cover most of the losses.

Facing limited penalties, moral hazard leads people to act in their own self-interest instead of guarding against large societal costs.

Some examples of moral hazard include:

• Not taking adequate precautions against theft because insurance pays for stolen items
• Engaging in reckless driving knowing that vehicle damage and medical bills are mostly covered
• Making unnecessary health insurance claims since patients face little cost for doctor visits and procedures

Ways Insurers Address Moral Hazard

Insurers and policymakers aim to reduce moral hazard without limiting insurability or useful risk-sharing. Some risk management tactics include:

Deductibles: Requiring out-of-pocket spending on small claims before coverage kicks in keeps patients, drivers, and others from overusing insurance for minor issues. High deductibles are very common in health plans today.

Co-insurance: Coinsurance policies require policyholders to cover a set percentage of each claim after meeting their deductible. This directly aligns incentives by ensuring the policyholder shares some costs.

Loss mitigation: Insurers institute preventive measures like recommending flu shots to reduce health risks or mandating deadbolts to lower theft claims. These steps curb avoidable claims that would otherwise arise from moral hazard.

Risk pooling: The very mechanism of insurance counters moral hazard. By pooling many people’s risks together, the societal costs of a few people’s risky behavior remain affordable for the group. No one person’s claims significantly impact the group’s overall claims rate.

The Tradeoff Between Insurance and Moral Hazard

Moral hazard is an unavoidable tradeoff for risk pooling’s affordability and security. While distorting incentives towards unnecessary risks, insurance also promotes economic growth and protects from hardship. Policymakers aim to balance usefulness against waste when regulating insurance and addressing moral hazard.