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Understanding and Preventing Moral Hazard

When we try to understand moral hazard, we inevitably relate it to issues in financial and economic agreements. However, moral hazard does not just relate to those types of transactions; it can be relevant to other people, professions, and even everyday relationships with others.

Moral hazard, as described by Investopedia, is the risks one party takes when they have entered a contract in good faith, but have provided misleading information, giving them incentive to take more risks, at the expense of the other party.

What is Moral Hazard?

Simply put, moral hazard is any risk a person takes that leaves another person or party to shoulder the consequences. One example may be when a borrower takes extreme risks because they know their mistakes will be covered.

The term “moral hazard” itself has a long history, and dates back to the 17th century. Early usage of the term, as it does now, held a negative connotation, that inferred fraud or immoral behavior.

In the past, moral hazard was most often seen as an issue mostly affecting insurance companies. However, it is not limited to a single profession. In most recent times, the term has been used to describe the issues that arise during economic crisis, when the government offers bailouts to large companies.

While moral hazard is a problem in itself, adverse selection is often one of the contributing factors to the moral hazard problem.

Adverse Selection and Moral Hazard

Adverse selection, according to Economics Help, is when a product or service is selected by certain people who are most likely to provide the worst returns for a company.

The idea behind this concept is that those who are most likely to purchase a product or service, are often those who stand to gain the most, while causing the greatest loss for the company.

One example of this might be an insurance company. If the company provides insurance to the general public, they are most likely to have those with pre-existing health issues, or those who are not health conscious, to sign up for their plans.

The reason is simple. The unhealthy group is more likely to need the insurance, whereas those who are healthy may not see the point. As a result of this adverse selection, a moral hazard is created.

To resolve the issue, many insurance companies require those who live an unhealthy lifestyle, or those with pre-existing conditions to pay higher rates. This includes smokers, those who are considered obese, and those who have a history of health problems.

Other Factors That Contribute To Moral Hazard

While adverse selection plays a major role in moral hazard, there are several other issues that can contribute. This includes:

  • A weak company policy.
  • A lack of benefits and incentives.
  • Not enough rules and regulations.
  • No performance evaluations.
  • Failure to identify underlying problems.

Moral Hazard Examples

Examples of moral hazard can be found in all businesses and professions. It can be as simple as employees’ behavior, or as intricate as a large company taking unnecessary financial risks because they are guaranteed a bailout. Here are a few examples of moral hazard.

Example 1: A salesperson who is not paid a commission

  • In this instance, the moral hazard lies in that the salesperson may not be motivated to do their best because there is no financial incentive for their work. If they are simply paid a hourly wage regardless of the number of sales they make, they realize only the company will gain from their efforts. As a result, they feel less inclined to work hard for the company, as they also realize they are the only ones who will note the loss.

Example 2: An employee on salary

  • In this example, an employee is paid a specific amount, regardless of how many hours they work. While they may be required to put in a minimum number of hours each week, they usually do not earn anything for hours worked beyond the minimum. The lack of incentive often results in the employee breaking rules and regulations in the company policy. This could be anything from not completing tasks to taking extra long breaks during their work day. In the end, the company may suffer a loss due to the employee’s lack of concern.

Example 3: People or companies who are insured

  • Certain people and companies who rely on insurance to save them in desperate times also might create a moral hazard. For example, a person who has car insurance that covers theft may not take the necessary precautions to avoid having their vehicle stolen. The same is true for a company that takes extra risks because they know their insurance company will cover specific losses.

Example 4: A large company that believes they will get a bailout

  • A company that believes they are too big and important to fail may also present a moral hazard. If they believe that they will receive a financial bailout due to safety nets that governments put into place, they are more likely to take unnecessary risks to generate profit.

How to Reduce Moral Hazard

One the best ways to decrease moral hazard is to make sure all parties involved stand to gain and lose as a result of performance. It requires that a balance is found among the company, its employees, and the population served.

According to Chron Small Business, there are several things that can be done to reduce moral hazard.

Identifying Problem Areas

  • The first step in reducing moral hazard is to identify what is causing the problem in the first place. This includes identifying problems among the company and the employee, as well as problems related the population the company serves. Once these problems are identified, regulations can be put into place to protect the best interest of everyone involved.

Developing a Good Policy

  • Implementing effective policies among employees can help reduce moral hazard. A good policy will include rules and regulations that will benefit both the employee and the company. This may also include prohibiting an employee from working with or for competitors, so that the company can safeguard against certain financial loss.

Offering Employee Incentives

  • Programs that are geared toward rewarding an employee for following protocol, or going the extra mile, can also reduce moral hazard. An employee that has the potential to earn bonuses, recognition, or a promotion is more likely to feel motivated to do their very best. They are also more likely to focus on the company’s long-term success as well.

Provide Solid Benefits

  • The lack of benefits and high turnover rates result in potential moral hazard. A person who does not visualize themselves having a long-term career with a company is less likely to focus on the values, goals, and success of that company. A good benefits package, along with a clear road to success within the company, will motivate an employee to work harder.

Conducting Performance Evaluations

  • Regular evaluations of individual employees will also reduce moral hazard. When employees know that their performance is being regularly monitored, and can have either positive or negative impact, they are more likely to adhere to company policy. Performance evaluations also help to identify problems and provide a chance to offer feedback to employees on where they need to improve.

Moral hazard is a problem that can be resolved if issues are identified and addressed. The answer is to find a balance that protects everyone involved, and hold each party accountable for their actions.

To eliminate the problem, it is important for a company to also understand adverse selection, and to develop techniques to avoid it. Once problems are identified, a plan can be put into place that will not only protect the company, but provide incentives to motivate employees, and offer the best service to the population that they serve.

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