Understand the difference between moral hazard and adverse selection


Moral hazard and adverse selection are both used in economics, risk management, and insurance to describe situations in which one party is disadvantaged due to the behavior of another party.

Moral hazard occurs when there is asymmetric information between two parties and a change in behavior of one party occurs after an agreement between the two parties is reached. Asymmetric information refers to any situation in which one party to a transaction has greater material knowledge than the other party. Moral hazard occurs frequently in the credit and insurance industries, but it can also exist in employer-employee relationships. Whenever two parties come to an agreement, moral risks can be present.

Adverse selection refers to a situation where sellers have more information than buyers, or vice versa, about some aspect of product quality, although usually the more knowledgeable party is the seller. Adverse selection occurs when asymmetric information is exploited.

Key points to remember

  • Moral hazard and adverse selection are both terms used in economics, risk management, and insurance to describe situations where one party is disadvantaged over another.
  • In a moral hazard situation, a party who enters into the agreement provides misleading information or changes its behavior after the agreement is concluded because it believes that it will not suffer any consequences for its actions.
  • Moral hazard occurs frequently in the credit and insurance industries, but it can also exist in employer-employee relationships.
  • Adverse selection refers to a situation where sellers have more information than buyers, or vice versa, about some aspect of product quality.

Moral hazard

In a moral hazard situation, a party who enters into the agreement provides misleading information or changes its behavior after the agreement is concluded because it believes that it will not suffer any consequences for its actions. When a person or entity does not bear the full cost of a risk, it may have an incentive to increase its exposure to the risk. This decision is based on what will give them the highest level of benefit.

There is always the risk that a party has not entered into a contract in good faith, and it can do so by providing false information about its assets, liabilities or credit capacity. This can happen in the financial sector in contracts between a borrower and a lender. Moral hazard is also common in the insurance industry.

Example of moral hazard

For example, suppose a homeowner does not have home or flood insurance, but lives in a flood zone. The owner is very careful and subscribes to a home security system that helps prevent burglaries. In the event of a thunderstorm, it prepares for flooding by emptying pipes and moving furniture to avoid damage.

However, the homeowner is fed up with always having to worry about potential burglaries and preparing for flooding, so they purchase home and flood insurance. Once his house is secured, his behavior changes. He cancels his home security subscription and does less to prepare for possible flooding. The insurance company is now more at risk of having a claim against them as a result of damage from flooding or loss of property.

History of moral hazard

According to research by economists Allard E. Dembe of Ohio State University and Leslie I. Boden of Boston University, the term moral hazard was widely used by insurance agents in England. Although the early use of the term implied fraudulent and immoral behavior, the word “moral” has sometimes been used to refer simply to subjective behavior in mathematics, so the ethical implications of the term are unclear. In the 1960s, moral hazard once again became a subject of study among economists. At that time, rather than being a description of the morality of the parties involved, economists used moral hazard to refer to inefficiencies created when risks cannot be fully understood.

Adverse selection

Adverse selection describes a situation in which one party to a transaction has more precise and different information than the other party. The part with less information is at a disadvantage compared to the part with more information. This asymmetry leads to a lack of efficiency in the price and the number of goods and services provided. Most information in a free market economy is transferred through prices, which means that adverse selection tends to result from ineffective price signals.

Example of adverse selection

For example, suppose there are two groups of people in the population: those who smoke and do not exercise, and those who do not smoke and exercise. It is common knowledge that those who smoke and do not exercise have a shorter life expectancy than those who do not smoke and choose to exercise. Suppose there are two people looking to purchase life insurance, one who smokes and doesn’t exercise, and the other who doesn’t smoke and exercises every day. The insurance company, without more information, cannot tell the difference between the individual who smokes and does not exercise and the other person.

The insurance company asks individuals to fill out questionnaires to identify themselves. However, the person who smokes and does not exercise knows that responding honestly will incur higher insurance premiums. This individual decides to lie and says that he does not smoke and that he exercises daily. This leads to adverse selection; the life insurance company will charge the same premium to both people. However, insurance is more valuable for the non-practicing smoker than for the practicing non-smoker. The non-practicing smoker will need more health insurance and ultimately benefit from the lower premium.

Insurance companies reduce exposure to large claims by limiting their coverage or increasing premiums. Insurance companies try to mitigate the potential for adverse selection by identifying groups of people who are at greater risk than the general population and charging them higher premiums. The role of life insurance underwriters is to assess applicants for life insurance to determine whether or not they should provide them with insurance or the amount of premiums to charge them. Underwriters typically assess any issues that may impact a candidate’s health including, but not limited to, height, weight, medical history, family, occupation, hobbies, driving record and the candidate’s smoking habits.

Other examples of adverse selection include the used car market, where the seller can learn more about a vehicle’s faults and charge the buyer more than the car’s value. In the case of auto insurance, an applicant may falsely use an address in a low crime rate area in their application in order to obtain a lower premium when they actually reside in an area where the break-in rate of cars is high.

Distinguish moral hazard from adverse selection

Both in moral hazard and in adverse selection, there is an information asymmetry between the two parties. The main difference is when it happens. In a moral hazard situation, the change in behavior of a party occurs after the conclusion of the agreement. However, in the adverse selection there is a lack of symmetrical information before the conclusion of the contract or agreement.


Martin E. Berry

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