Research suggests[i] that the term “moral hazard” dates all the way back to the 17th century, and was later utilized by insurance companies in England in the late 19th century. It was not until the 1960s that the concept was used in terms of the economy and was used to describe ineptitudes that potentially occur when risks are relocated.
In more general terms, the concept of moral hazard describes the behavior of a party in a situation where the party is not fully exposed to the risk associated with the activity[ii]. Moral hazard occurs when a party (whether it be an individual or an organization) engages in activity less carefully than it would if it was required to bear the full responsibility and consequences of its actions. In essence, the party is less inclined to prevent an occurrence because they are somehow insulated from the negative consequences.
The concept of moral hazard is not limited to the area of insurance agreements, but rather it is also applied to the courts interpreting contracts in a general sense. “According to Posner, the moral hazard problem arises when a party is ‘insured’ against a risk ‘that he could have prevented at a reasonable cost.’…undesirable incentives are created if a party that could have done something to avoid or minimize the loss is let off the hook by a court. Thus, when courts employ default rules to allocate risk among parties to a contract, the court is in a sense ‘writing insurance’ ex post. One implication of this is that courts, acting as an arbiter of risk by construing a contract, must be wary of creating conditions for moral hazard.”[iii] This definition of moral hazard and when it arises can offer a more contextual sense of the broad nature of the idea.
Some believe that moral hazard is a necessary evil of information asymmetry. The idea that a party to a transaction who has more information than another is shielded from risk makes sense and helps to explain the theory. The party with less information is then required to trust that the other party will behave appropriately, without ever knowing if that is the case. Therefore, it is logical that the concept of moral hazard has traditionally been applied in the insurance context[iv]. Moral hazard occurs when the insured party behaves in a manner that raises the cost on the part of the insurer as a result of the insured party’s insulation from all, or part of the risk.
[i] Dembe, Allard E. and Boden, Leslie I. (2000). “Moral Hazard: A Question of Morality?” New Solutions 2000 10 (3). 257-279
[ii] See generally at http://www.investopedia.com/terms/m/moralhazard.asp
[iii] Eric D. Beal. “Posner and Moral Hazard”. 7 Conn. Ins. L.J. 81 (2001).
[iv] Arrow, Kenneth (1965). Aspects of the Theory of Risk Bearing. Finland: Yrjo Jahnssonin Saatio. OCLC 228221660. See also Arrow, Kenneth (1971). Essays in the Theory of Risk-Bearing. Chicago: Markham.
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