Moral hazard – definition

Moral hazard is the tendency for individuals and organisations to behave inefficiently when they are able to transfer the risk to a third party. This means that, once insured against the risk, the insured party may take risks that they would not take if they had to bear the full cost associated with any loss.

In short, being insured against a risk may encourage individuals to take risks which they would not otherwise take.

This has many applications in economics, including the issue of state support for the banking industry. The belief that banks would be bailed out to prevent them ‘failing’ is often is frequently cited as encouring excessive risk-taking, and contributing to the financial crisis between 2008 and 2010.

At its heart is the issue of information failure – insurers and those insured do not share full information about the risks involved, or about the intentions of the other party. Typically, the insured has the advantage of knowing more than the insurer, although the insurer is the party that bears the cost.