moral hazard

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Moral hazard

The risk that the existence of a contract will change the behavior of one or both parties to the contract, e.g. an insured firm will take fewer fire precautions.

Moral Hazard

The risk that a party to a transaction or activity is not acting in good faith, or that one party has perverse incentives to act in a manner detrimental to the counter party. Moral hazards may exist for almost anything. For example, a plan for a government to bail out delinquent mortgages has the moral hazard that it will encourage mortgage holders to refrain from making their home payment. Likewise, deregulation has the moral hazard that companies will use it as incentive for short-term, unsustainable profits, rather than proper economic growth.

moral hazard

a situation in which one of the parties to a CONTRACT has an incentive, after the contract is agreed, to act in a manner that brings benefits to themselves at the expense of the other. For example, employees may work less conscientiously than expected by the terms of their CONTRACT OF EMPLOYMENT (i.e. they indulge in ‘shirking’ and time wasting). See PRINCIPAL-AGENT THEORY, AGENCY COST.

moral hazard

a situation in which one of the parties to a CONTRACT has an incentive, after the contract is agreed, to act in a manner that brings benefits to himself at the expense of the other party to the contract. Moral hazard is a consequence of hidden actions in TRANSACTIONS, that is, actions that parties to a transaction may take after they have agreed to execute a transaction. If these actions are unobservable to the other parties to the transaction and if they may harm the interests of these other parties, then these hidden actions may prevent the successful completion of the transaction.

Even the anticipation that such hidden action is possible may prevent the transaction from taking place. For example, if insurance companies offer fire insurance at premiums that reflect a normal likelihood of fire damage, there is a danger that people who are insured against fire accidents will tend to behave less cautiously or even with malicious intent so that fire claims upon insurance companies are excessive.

Moral hazard can also apply to EMPLOYMENT CONTRACTS where employees may work less conscientiously than was expected in their employment contracts (i.e. they engage in ‘shirking’) if work supervision is not extensive (see TEAM PRODUCTION). Moral hazard can apply particularly to employment contracts of senior managers who might not act strictly as agents of the shareholders but pursue their own goals in the absence of sufficient shareholder scrutiny (see PRINCIPAL-AGENT THEORY). See ASYMMETRICAL INFORMATION.

References in periodicals archive ?
Were the fire caused, however, by careless storage of flammable materials (i.e., a morale hazard), the insurer might nonetheless be obliged to pay compensation to the policy-holder.
Where the occupier of a building situated in a floodplain uses the basement to store valuable items, not realizing that the building has been flooded in the past, this presents a morale hazard. A builder who deliberately constructs for re-sale, to an unsuspecting buyer, a non-flood-proof building on a piece of land known to be inundated regularly, creates a moral hazard.
This application indicates that government subsidisation of such insurance programs may create a morale hazard that increases climate change-related risks, even though such insurance may be provided as an adaptive response to reduce risk.
The New Zealand example illustrates how an alteration of an adaptive response--the removal of subsidies and, in particular, subsidized crop insurance--reduced the morale hazard. Without subsidies, farmers began to choose adaptation options that reduce the likelihood of crop losses and that decrease their potential losses should this peril occur.
Even where subsidized flood insurance is purchased, the evidence suggests that it creates a morale hazard that results in a higher risk of flood damage than would otherwise occur.
Consequently, it appears that one effect of subsidized flood insurance is to maintain the presence of higher value properties in areas where the peril of flooding exists--creating a morale hazard.
In fact, the entire premise on which subsidized flood insurance in the United States is based may be considered a morale hazard. The underlying assumption of the National Flood Insurance Plan is that continued occupation and economic activity of floodplains is in American society's interest, notwithstanding that lower intensity use of land in flood-prone areas reduces the numbers of people and properties exposed to the peril of flooding (Burby 2001).
So, too, would the morale hazard persist, for buildings would continue to be occupied and built in areas prone to flooding.