Moral Hazard Vs. Adverse Selection

Insurance provides protection for the insured and can also be profitable for companies providing the product. There are also risks for both the provider and policy holder, which is where moral hazard and adverse selection come into play. The two terms are often used to evaluate and manage risk within insurance markets and economics.

Moral Hazard

The belief that a person engages in riskier behavior once they’re insured is known as moral hazard. They engage in said behavior because they know the entity providing the insurance will take responsibility for any negative consequences that occur.

For example, an individual with life insurance may decide to do more risky activities like skydiving or racing when they know insurance will cover their funeral costs and family when they die. Likewise, someone with home insurance may not replace their smoke detector batteries for months because they know if there is a house fire, they’re financially covered. A real-life example of moral hazard could be the 2008 global financial crisis driven by banks taking aggressive risks because they knew they’d be bailed out by the US government.

Moral hazard is important because it affects both parties in a contract when things go wrong. If a person does engage in riskier behavior and get hurt or lose their house, while they may have a financial safety net, insurance companies may raise deductibles in turn. Likewise, when banks crash and are bailed out by the U.S. government, taxpayers foot the bill in return.

Adverse Selection

Adverse selection is when one party knows more about a transaction than the other also known as information asymmetry.

As an example, someone selling a car may have more information about the true state of the car whereas the tentative buyer doesn’t. This can create apprehension about going ahead with a transaction out of fear of being scammed. Likewise, an investor selling penny stock on the OTC market may have more information about the true value of the investment than a potential buyer, creating an imbalance.

The risk of adverse selection is it can lead to market failures when companies can’t effectively assess risk due to lack of information from the other party in the agreement. As a result, companies may end up attracting more high-risk customers. Adverse selection often happens within the life insurance industry.

To put things into perspective, if a person has a high risk of dying within the next decade or leads an unhealthy lifestyle, they may want to buy life insurance. If the insurance company isn’t aware of this, attracts multiple customers who fall into this category, and charges them an average price, they would end up with the short end of the stick. This lack of information affects customers as companies usually increase prices to manage risk. Said companies may also waste resources trying to figure out who their target customers are.

On the contrary, if an insurance company raises the premiums to try and prevent that loss, they may be less attractive to younger healthier customers . This could be because the policy cost is relatively high compared to the perceived value.

Adverse Selection Vs Moral Hazard

Moral hazard and adverse selection are similar, but the difference is in the timeframe. Moral hazards tend to happen after terms of an agreement have been concluded while adverse selections happen before. Both adverse selection and moral hazard can lead to a loss for companies and customers alike. That said, the goal is always to minimize risk and maximize profits.