Context: insurance, risk management

Moral hazard refers to the tendency where people who have acquired insurance on a particular item (whether a house, car, life or liability) will take less care in protecting such an item against loss. This is because it is less "painful" (or formally, utility does not decrease as much) to suffer the loss and have the insurance company cover it, and that prevention of loss (such as placing alarms in houses) are costly.

Along with adverse selection (=antiselection), moral hazard is a risk that an insurance company that wants to avoid ruin must manage. Usual strategies include:

  • Charging a deductible (=excess) whenever a claim is lodged. Thus the insured still has to pay something whenever he or she claims. This will hopefully drive the insured to take more care.
  • No claim discount schemes. Here the premiums are substantially reduced for those insured that has not made a claim during a certain time period. Insured are extremely attracted to these discounts, and thus are driven to avoiding claims. It so happens that such schemes are so consistent with credibility theory.
  • Policy conditions placed on the insurance contracts, particularly exclusions. These are the things where the insurance company will not pay. While these will drive down claims, they also have an effect of annoying customers. So the insurance company will have to be careful what types of exclusions are placed on the policy, and whether everybody else is doing the same.