Morale hazard

Morale hazard

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In insurance
Insurance
In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...

 analysis, morale hazard is an increase in the hazards presented by a risk arising from the insured's indifference to loss because of the existence of insurance. Insurance analysts distinguish this from moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...

. The use of the term in this way dates back to at least 1968, when it was used in the fourth edition of Casualty Insurance.

This usage differs from that in economic theory (see Contract theory
Contract theory
In economics, contract theory studies how economic actors can and do construct contractual arrangements, generally in the presence of asymmetric information. Because of its connections with both agency and incentives, contract theory is often categorized within a field known as Law and economics...

). In economics, whenever insurance of a risk causes decision-makers
Decision making
Decision making can be regarded as the mental processes resulting in the selection of a course of action among several alternative scenarios. Every decision making process produces a final choice. The output can be an action or an opinion of choice.- Overview :Human performance in decision terms...

 to act in a way that increases the risk, this is called moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...

, regardless of whether the change in behavior is conscious or malicious.

Insurance

  • Insurance can be seen as discouraging preventive measures, such as proper fire prevention. For example, the expectation of federal government disaster aid seems to encourage the residents of Malibu, California to let bushes and trees grow near their houses, as part of their landscaping. This increased vegetation raises the risk of fire damage to their houses. Equally, the prospect of federal aid may depress insurance premiums, thus providing people with an incentive to settle in hazardous areas. The Cato Institute
    Cato Institute
    The Cato Institute is a libertarian think tank headquartered in Washington, D.C. It was founded in 1977 by Edward H. Crane, who remains president and CEO, and Charles Koch, chairman of the board and chief executive officer of the conglomerate Koch Industries, Inc., the largest privately held...

     has argued that the federal government should not subsidize the reconstruction of New Orleans, for precisely this reason.

  • Automobile insurance reduces the costs to insured people who have accidents, making people less cautious when driving (compared to how they would drive if they paid 100 percent of the damages they cause in an accident).


Insurance companies often try to stem the problem of morale hazard by risk reduction measures, such as insisting on the ownership of fire extinguishers (in the case of fire insurance), or offering price reductions (for example, if a burglar alarm is installed in a home). Another defense against morale hazards is deductible
Deductible
In an insurance policy, the deductible is the amount of expenses that must be paid out of pocket before an insurer will pay any expenses. It is normally quoted as a fixed quantity and is a part of most policies covering losses to the policy holder. The deductible must be paid by the insured,...

s, where policy holders are still responsible for limited loss, and are therefore still motivated to avoid loss, albeit to a lesser extent.