Feb 21, 2013

Moral hazard


Moral hazard

It is usually applied to the insurance industry. Insurance companies worry that by offering payouts to protect against losses from accidents, they may actually encourage risk-taking, which results in them paying more in claims. Insurers fear that a "don't worry, it's insured" attitude leads to policyholders with collision insurance driving recklessly or fire insured homeowners smoking in bed. 

The idea of a corporation being too big or too important to fail also represents a moral hazard. If the public and the management of a corporation believe that the company will receive a financial bailout to keep it going, then the management may take more risks in pursuit of profits. Government safety nets create moral hazards that lead to more risk taking, and the fallout from markets with unreasonable risks - meltdowns, crashes, and panics - reinforces the need for more government controls. Consequently, the government feels the need to strengthen these nets through regulations and controls that increase the moral hazard in the future. 

The alternative to creating a moral hazard is to simply let corporations fail when they risk too much and let the stronger corporations buy up the wreckage. This theoretical free-market approach should remove any moral hazard. In a true free market, companies would still fail, just as houses burn down whether they’re insured or not, but the impact would be minimized. There would be no industry-wide meltdowns because most companies would be more cautious just as most people choose not to smoke in bed whether or not they are insured. In both cases, the risk of burning up is enough to prompt serious second thought on any risk taking behavior. 

True free market capitalism doesn't exist, so the taxpayers of many countries are the unwilling insurers for markets. The problem is that insurers profit by selling policies, whereas taxpayers gain little or nothing for footing the bill on the policies and bailouts that create moral hazards. 
Moral hazard can arise in the insurance industry when insured parties behave differently as a result of having insurance. There are two types of moral hazard in insurance: ex ante and ex post.

 Ex-Ante Moral Hazard - Ed the Aggressive Driver: Ed, a driver with no auto insurance, drives very cautiously because he would be fully responsible for any damages to his vehicle. Ed decides to get auto insurance and, once his policy goes into effect, he begins speeding and making unsafe lane changes. Ed's case is an example of ex-ante moral hazard. As an insured motorist, Ed has taken on more risk than he did without insurance. Ed's choice reflects his new, reduced liability.
Ex-Post Moral Hazard - Marie and Her Allergies: Marie has had no health insurance for a few years and develops allergy symptoms each spring. This winter she starts a new job that offers insurance and decides to consult a physician for her problems. Had Marie continued without insurance, she may never have gone to a doctor. But, with insurance, she makes an appointment and is given a prescription for her allergies. This is an example of ex-post moral hazard, because Marie is now using insurance to cover costs she would not have incurred prior to getting insurance.
Morale hazard
Circumstance that increases the probability of occurrence of a loss, or a larger than normal loss, because of an insurance-policy applicant's indifferent attitude after the issuance of policy. For example, he or she might be careless in locking the doors and windows when leaving home. In common usage, morale hazard indicates that the insured party unconsciously  changes their actions or behaviors, as opposed to a deliberate change in order to cheat the system or benefit from his or her circumstances. Compare with moral hazard.

Difference between Morale Hazard and Moral hazard

Morale hazard:

An attitude that increases the probability of loss from a peril. In insurance context, the attitude of insured; Attitude of insured to think “Its insured so why should I worry about safety of my house/property/own health. If anything goes wrong, insurer is there to indemnify me. So, Why should I worry about safety?” is an example of a morale hazard. Insured with this kind of attitude tend to act carelessly. 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). Refers to individual’s Carelessness – Ex ample – Rash driving after getting auto insurance or keeping doors open after purchasing a insurance for house.
Moral hazard:
A condition of morals or habits that increase the probability of a loss from a peril. This hazard to an insurance company resulting from uncertainty about the honesty of the insured. Ex ample – Insured giving false information to insurer to get or to purpose an insurance policy in favor of i nsured or raising a claim with exaggerated loss.
Insurance Retention
An insurance retention is the portion of an insurance claim paid by the insured instead of the insurance company. A deductible is a common example of a retention although there are other types of retentions. Retentions allow the insured to reduce insurance premiums while assuming a portion of the risk being insured.

Self-Insured Retention
A self-insured retention (SIR) is a portion of each insurance claim that is not insured by the policy and requires the insured to pay before insurance becomes effective. For example, if there is a Rs.6,500 self-insured retention on a Rs 650,000 general liability policy, the insured must pay the first Rs 6,500 of any claim before the insurer will respond.
Deductible
A deductible on a liability policy is an amount that must be reimbursed by the insured to the insurer for each paid claim. Unlike a self-insured retention, insurers are obligated to immediately handle third party claims and seek reimbursement from their insureds. Insurers may not resist paying third-party claims even if their insureds do not reimburse deductible obligations.
Retrospective Rated Policies
Instead of a defined retention that applies on every claim, insureds may arrange for a retrospectively rated policy to share a proportion of all losses with the insurer. These retentions may vary by claim type and often have a maximum amount of aggregate retention thereby providing some cap on exposure to loss.
Moral Effect
Insurers benefit from retentions because their insureds have a financial stake in preventing or minimising the effect of claims. This eliminates the fear that insureds would act recklessly knowing they are fully insured with no financial impact other than potentially increased annual premiums. Some insurers require all policies to have some level of retention as a method of loss control.

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