Introduction
While moral hazard is a common term used in the finance world, it is most commonly used in group insurance and other individual insurance space. It is because human beings, when they are freed from boundaries, often tend to overdo😑what they would have done otherwise.
Moral hazard in the insurance world is the classic example of people often taking unwanted risks that they would have skipped otherwise. What is a moral hazard, and why should you care? This article discusses how it works and more.
What is a moral hazard?
A moral hazard refers to an inclination of those insured to act differently😑when they are insured than when they lack insurance protection. It is not that moral hazard is only applicable in the insurance world. People with theft insurance not being cautious enough about items insured, companies looking for subscribers to subscribe to their equity shares and having underwriters, and more, are examples of how someone reacts differently than when they lack the buffer.
In life, risk and reward usually come together. When you take a risk, and things don’t go as planned, you will have to bear the consequences. With moral hazard making its presence felt, things don’t typically take the same turn😒.
‘Moral hazard’ is essential in group insurance because people often tend to take significantly higher risks because they know they have insurance to cover the results. But if people subscribe to insurance, it automatically gets into their heads that they are secured and can now take more risks. As a result, insurance companies are circumspect while offering payouts to safeguard against unwanted losses, such as theft and accident.
Moral hazard beyond the insurance world
Moral hazard prevails in every stratum of our lives. Simply put, wherever there is a risk element that others may have to bear if gone wrong, moral hazard will come into the picture.
One of the most significant examples of moral hazard would be the 2007-08 financial crisis and the Great Recession🥴. When the dot-com bubble burst, interest rates sank to their lowest, enabling credit to become dirt cheap. It resulted in those previously unable to afford housing loans running to banks and financial institutions to get one. These got packaged as ‘low-risk’ investments by banks and sold off to investors looking to make easy money by giving loans to the general public.
When the economy began its recovery, the interest rates were significantly increased. It resulted in people being unable to meet their interest dues, and many people abandoned their properties because they were worth considerably lower than the debt. It resulted in a loss of trillions of dollars for financial institutions and pushed banked to the verge of bankruptcy.
How does it work?
We all remember the case of Titanic and how it was considered unsinkable. But it too fell🥴 because no one thought what if it sinks. Similarly, in life, when we have a group medical plan or any other insurance that covers specific claims, we often tend to focus only on the good side and do not wish to delve into the negatives. It forms the basis of moral hazard. Here, an individual takes an additional and often unwanted risk that negatively results in the transaction or any of the parties involved.
For example, let us consider the case of an individual part of group cover being ill. Even though the individual insists on getting a routine checkup, the family members may think that they have a sizable insurance cover and do not worry.
So they wait for days before visiting a doctor to find out that the individual had a severe illness that could be treated if they had paid a visit a few days back. In case of the death of the jacked-up price of the individual’s hospitalization, the insurance company will have to come into the picture and reimburse the higher claim.
Moral hazard can lead to adverse selection
When people develop the habit of undertaking higher risks because of having group insurance or otherwise, it automatically seeps down to them looking for someone to bear the consequences on their behalf. It leads to people asking for insurance with higher coverage merely to cover their deeds.
Such a thought process is unknown to the other party, and they are at a disadvantageous position when they enter an insurance contract. It works the same way, even for other insurance types, too.
The insurance provider uses a plethora of ways to counter coming across such detrimental behavior, such as having a one-on-one conversation with the potential policyholder, asking them to fill out surveys to understand how to classify them, and more. But it would only work if the said person decides to answer truthfully, which in many cases doesn’t happen. It leads to adverse selection, where the insurer charges the same premium from such individuals even though they bear a higher risk of meeting a claim request.
Wrap up
Moral hazard is a common occurrence in the insurance world, and it occurs because insurers have asymmetric information about their clients. It has forced insurers to opt for co-pay where the insured will pay partially for their services. It is a move to make people more aware and stop them from taking unwanted rash calls.
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