Steven Nickolas* explains two terms used in economics – risk management, and insurance – to describe situations where one party is at a disadvantage.
Moral hazard and adverse selection are two terms used in economics, risk management, and insurance to describe situations where one party is at a disadvantage.
Moral hazard occurs when there is asymmetric information between two parties and a change in the behaviour of one party after a deal is struck.
Adverse selection occurs when there’s a lack of symmetric information prior to a deal between a buyer and a seller.
Asymmetric information, also called information failure, happens when one party to a transaction has greater material knowledge than the other party.
Typically, the more knowledgeable party is the seller.
Symmetric information is when both parties have equal knowledge.
Moral hazard
Moral hazard occurs when a party that has agreed to a transaction provides misleading information or changes their behaviour because they believe that they won’t have to face any consequences for their actions.
Moral hazard is the risk that one party has not entered into the contract in good faith or has provided false details about its assets, liabilities, or credit capacity.
In addition, moral hazard may also mean a party has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles.
Adverse selection
Adverse selection describes a situation in which one party in a deal has more accurate and different information than the other party.
The party with less information is at a disadvantage to the party with more information.
This asymmetry causes a lack of efficiency in the price and quantity of goods and services.
Most information in a market economy is transferred through prices, which means that adverse selection tends to result from ineffective price signals.
Example of moral hazard
For an example of moral hazard, consider the implications of buying insurance.
Let’s assume a homeowner does not have homeowners’ insurance or flood insurance and lives in a flood zone.
The homeowner is very careful and subscribes to a home security system that helps prevent burglaries.
When there are storms, they prepare for floods by clearing the drains and moving furniture to prevent damage.
However, the homeowner is tired of always having to worry about potential burglaries and preparing for floods, so they buy the home and flood insurance.
After their house is insured, their behaviour changes and they are less attentive, they leave doors unlocked, cancel the home security system subscription and do not prepare for floods.
In this case, the insurance company is faced with the risks of floods and burglaries and their consequences, and the problem of moral hazard arises.
Example of adverse delection
Life insurance premiums can be a way of looking at an example of adverse selection.
Let’s assume there are two sets of people in the population, those who smoke and do not exercise, and those who do not smoke and do exercise.
It is common knowledge that those who smoke and don’t exercise have shorter life expectancies than those who don’t smoke and do exercise.
Suppose there are two individuals who are looking to buy life insurance, one who smokes and does not exercise, and one who doesn’t smoke and exercises daily.
However, the insurance company, without further information, cannot differentiate between the individual who smokes and doesn’t exercise and the other person.
The insurance company asks the individuals to fill out questionnaires to distinguish them.
However, the individual who smokes and doesn’t exercise knows that answering truthfully means higher insurance premiums, so they lie and say they don’t smoke and they do exercise daily.
This leads to adverse selection, where the life insurance company is at a disadvantage and then charges the same premium to both individuals.
However, insurance is more valuable to the non-exercising smoker than the exercising non-smoker because one party has more to gain.
The non-exercising smoker needs health insurance more and benefits from the lower premium.
Key takeaways
Both moral hazard and adverse selection are terms used in economics, risk management, and insurance to describe situations where one party is at a disadvantage to another.
Moral hazard is the risk that one party has not entered into the contract in good faith or has changed their behaviour after a deal is struck because they believe that they won’t have to face any consequences.
Adverse selection is when sellers have information that buyers do not have, or vice versa, about some aspect of product quality.
It is also the tendency of those in dangerous jobs or high-risk lifestyles to purchase life insurance.
* Steven Nickolas is a freelance writer and former investment consultant.
This article first appeared at www.investopedia.com.
