Definition: Moral hazard refers to the risk that a borrower engages in unethical activities, leading him to default on a contract.
What Does Moral Hazard Mean?
What is the definition of moral hazard? Moral hazard arises when both parties have incomplete information about each other (information asymmetry) or when they have different incentives and expect to realize different gains. One party provides deceptive financial information or is willing to take rare risks to earn a profit before the contract matures.
Each party has the incentive to gain an extra profit by acting against the principles of the agreement. Each party has the incentive to act deceptively to capitalize on the other party’s ignorance about certain facts pertaining to the contract.
Let’s look at an example.
Peter has a weekend house, where he goes every second week to rest. Although he should have insured the property against damages, the cost was high, and Peter could not afford it at the time. On the other hand, having the property uninsured incurs the risk of huge losses in case of fire or burglary. However, Peter does not equip the property with highly sensitive burglar alarms, nor does he hire security to watch over the property while he is not there.
However, if the property is uninsured for its full value, and it gets burnt, there is a case of information asymmetry because the insurance company may assume that Peter was looking after his property, although he wasn’t. So, Peter had the incentive not to look after the property, causing the insurance company to undertake the losses.
In this case, the insurance company has to determine several assumptions. For instance, if the property was insured, the possibility of getting burnt would be 10%. So, if the property costs $200,000, the insurance cost would be $20,000. If the property had been insured, the possibility of getting burnt would be 30%, so the insurance cost would be $60,000. Therefore, by having the property uninsured and not looking after it, Peter causes the insurance company to lose $40,000 from the contract.
Define Moral Hazards: Moral hazard means the danger that one party to a contract will act unethically and will not hold up his end of the contract.