Defining Moral Hazard through Examples

By Phineas Upham

When the country was debating whether to pass the Affordable Care Act, one of the ideas that kept coming up repeatedly was “moral hazard”. This concept wasn’t well-defined in many cases, but moral hazard is an important part of why we rely on regulation and how we exchange money.

In the case of the ACA, moral hazard was represented by the very real possibility that certain people would only sign up for health insurance if they were sick and would not pay into the pool otherwise. This presented a moral hazard, because one party was far more aware of the potential risk than the other.

Moral hazards tend to be based around information asymmetry, where one party knows more than the other about a particular subject. The hazard occurs when the party with the most information uses that advantage to their benefit. Knowledge is power, in a very real sense, and regulation works to curb some of the potential problems that moral hazard presents.

It’s also important to understand that moral hazard is not strictly limited to lenders. If a borrower uses the money he or she acquires in any manner not thoroughly discussed in the outlying contract, it can present a problem for the lender.

Employers also experience this type of hazard, which occurs when employees are not properly observed or managed; it may be difficult to run a department efficiently. Hazard is important because taxpayers often pay for that risk burden, so economic policy is based around trying to curb moral hazard to some extent in order to decrease that risk.

About the Author: Phineas Upham is an investor at a family office hedgefund, where he focuses on special situation illiquid investing. Before this position, Phin Upham was working at Morgan Stanley in the Media and Telecom group. You may contact Phin on his Phineas Upham website or Facebook page.