Definition of moral hazard

In insurance, the chance that the insured will be more careless and take greater risks because he or she is protected, thus increasing the potential of claims on the provider. The concept can be extended to any contract (such as a loan from the IMF to a country in financial crisis) that by its existence could prompt a signatory to take unnecessary risks. [1]

Moral hazard arises when a contract or financial arrangement creates incentives for the parties involved to behave against the interest of others.

Example

There are concerns that some individuals that take out large insurance policies to cover specific risks are likely to claim against such policies. There are also concerns that some borrowers that take on loans at very high interest rates are likely to have incentives to default.

Insurance firms and banks use screening techniques to try and identify such customers and monitor their behaviour.

Moral hazard occurs once a contract or financial arrangement has been agreed upon. [2]

Discussion