In economics, the term moral hazard refers to the observable fact that people will act differently if the risk of their actions has been moved to another participant.
The costs of good luck and bad luck
Insurances shift the risk (in part or fully) of bad luck away from the individual. Of course, this willingness to take the risk comes at a price.
For the insured individual, this means two things:
- Having good luck is now associated with costs: If nothing happens, the individual paid the insurance fees for nothing.
- At the same time, the cost of having bad luck changed: If an insurance pays $900 in the case of an accident with $1000, the cost of the accident (in the eyes of the individual) sinks to $100.
Assuming that individuals act with their own benefit in mind, this change in costs will lead to a change in behavior.
A person who purchased full insurance on a rental car (protecting it against all dents and scrapes of any kind) is less likely to take good care of the car because he knows that he will not have to pay for any damage to it.
In this case, the cost of bad luck and the cost of good luck are the same: Whatever the person paid for the insurance. Thus, the incentive to be careful is quite low (a person may still feel guilty, fear being regarded as a bad driver by his friends, etc.).
Circular effects in costs
The presence of these moral hazards leads to an increase of insurance costs due to greater losses than would occur in the absence of insurance. Of course, this increase in costs leads to a change in the reasoning of the individual, moving the costs of good luck and bad luck closer together and thus lowering the incentive to avoid accidents.
- Moral Hazard and Adverse Selection by Robert Schenk