Moral hazard refers to the risk that a contract has not been entered into in good faith. This typically includes one of the members in the agreement providing misleading information or one of the parties having an incentive to take unusual risks before the contractual agreement concludes.
Insurance is largely about managing risk. Providers structure coverage in part based on the likelihood that policyholders will need certain services and will make certain claims. Those who buy insurance, on the other hand, may behave differently if they know they are covered in the event of a mishap. This tendency may increase the risk that they will use their insurance, but the specifics of what human behaviors change when coverage is in place are difficult for the insurer to predict.
This is called "moral hazard" in the context of insurance. A 2016 study in the Journal of Medical Ethics and the History of Medicine actually identified two kinds of moral hazards in the context of health care: provider moral hazards, from those promoting unnecessary, but insurance-covered, services; and consumer moral hazards, from patients making excessive use of health care coverage. Technically, moral hazards can also include the most extreme cases of deliberate acts to avail oneself of insurance proceeds, such as in the case of an insurance beneficiary burning down the building covered by a fire policy.
How Do Insurance Companies Account for Moral Hazard?
Insurance companies try to mitigate moral hazard by structuring policies that incentivize behavior that does not lead to claims and penalizing actions that do. It can also take the form of more practical strategies like deductibles and premium reduction for fewer claims. It's a constant balancing act, however, as insurers struggle to create a fair system given the limited information they have about those who purchase their policies.
How Does Moral Hazard Come Into Play?
This tends to happen when one party to the insurance contract knows more than the other. One example from the 2008 financial crisis, outside of the insurance industry, is when lenders approved mortgages for people without the ability to pay, while the investors who bought the bundled mortgages didn't know default was likely. In the case of health insurance or vehicle insurance, companies can't watch insureds around the clock, so they may be unaware of behaviors that are detrimental to their physical health or safety on the road. This would include exercising poor driving skill, not wearing a seat belt, or excessive use of alcohol or illicit substances.
Another issue is the overuse, or deliberate misuse, of certain types of coverage. The 2016 study in the Journal of Medical Ethics examined reasons why individual patients may defraud the system. In its analysis, the paper noted that health care costs in the country in question, Iran, was about 7 percent of gross domestic product. That number was rising as 2 percent of the population was under the poverty line and information about these individual's health status was largely unknown.
In its survey, the study identified some reasons why health care fraud happened:
- Patients with chronic conditions wanted to pay less
- Patients found treatment costs unaffordable and wanted to protect against cost uncertainty
- Patients viewed doctors who prescribed many drugs as better practitioners
- Patients did not feel obliged to use their own insurance card, sometimes using another's coverage
In order to solve some of these issues, the study recommended better supervision of prescribing doctors, monetary exemptions for low-income individuals and education about the use of another person's health insurance.
Matching Insurance Coverage to Policyholder Risk
For insurers outside the health care context, the struggle is to adjust premium rates in order to account for the real risk of coverage. Moral hazard increases the risk, not necessarily because of deliberate fraud, but because of lack of care as a result of knowing that the item is fully covered. If an item is insured against theft, the company may reason that the probability that it is stolen against the payout cost in the event of a claim is the monetary risk. That risk changes once coverage is in place, but only because people become less cautious about preventing theft.
For example, a $5,000 jet ski may have a 5 percent chance of loss through theft, leading to a risk amount of $250. If the jet ski is insured, theft is more likely, so the company may reason it is now 25 percent, or $1,250. Because of moral hazard, insurance companies therefore have to use strategies to account for this difference. These include:
- Deductibles
- Higher premiums
- Lower premiums with proof of mitigation against risky behavior
The insurance company also wants to make policies affordable. However, this can create a perpetual push-and-pull to find a fair and financially sound insurance policy. In an ideal scenario, insurers would have the maximum information about insureds as possible, in order to most effectively define the risk.
Consumer Real Estate Information for Insurers
One significant piece of information available to commercial insurers is real estate data. Fortunately, DataTree allows you to search real estate information and track the financial history of insurance applicants. This way, providers can guard against unnecessary moral hazards. DataTree is available for a free trial, so insurance companies of all sizes can get a sense of its effectiveness without risk.