A Primer on Moral-Hazard Models

M oral hazard, a long-time concern in the insurance industry, is increasingly being recognized as a concern in the regulation of banking and other financial industries. A classic example of its possible perverse effects is the selling of a fire insurance contract to a group of uninsured individuals. If the premiums are based on the actuarial data of this group’s loss experiences, then the contract will be unprofitable. The reason for this loss is that with the introduction of fire insurance, insured people take fewer precautions than before against fires, raising losses above historical levels. It is this adverse effect of insurance on people’s behavior that is moral hazard, and it is because of these adverse effects insurance contracts frequently contain clauses that attempt to minimize this behavior such as deductibles and copayments. Moral Hazard — The effect of insurance on insureds’ behavior.