Ron Paul: Federal Flood Insurance - A Moral Hazard We Can't Afford

Moral
Hazard is a situation in which an individual party gets involved in a risky
event knowing that it is protected against the risk and the other individual
party involved will incur the cost of the risk. [1]

Moral Hazard arises when
one party has more information than the other, or both parties have incomplete
information. 

Moral
Hazard is one of the main reasons for market failure in the economy today, and
perhaps the biggest example of a moral hazard is in the case of insurance.

The
term ‘moral hazard’ originated in the insurance industry. Insurers need to
grant coverage in order to generate income from insurance premiums, but to gain
profit, they must pay as few claims as possible. [2]

Moral
hazards arise in the insurance industry when insured parties behave differently
as a result of having insurance.

For
example, if a car is insured, the driver then knows that he or she will be
protected in the case of an accident, which will cause him or her to drive
rashly, because now, someone else is going to incur the cost if something
happens to the car.

In
this way, insurance companies, by protecting their clients from things like
fire or car accidents, are technically encouraging risky behavior, such as
heavy smoking, not wearing seat belts, and speed driving. [3]

In
the case of companies and businesses, entrepreneurs can take advantage of
insurance because of limited liability.

Insurers are now aware of
moral hazards, and may prevent them, by charging higher premiums, or try to
decrease their exposure by shifting a portion of liability to policyholders in
the form of deductibles and co-payments.

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[1]
‘Definition of Moral Hazard’. The Economic
Times. Web. 10 Jan. 2016.

[2]
‘Moral Hazard: A Bump in the Contract Road’. Tisa Silver. Investopedia. Web. 10 Jan. 2016.

[3]
‘Moral Hazard in Economics’. Aaron Hill.
Study. Web. 10 Jan. 2016

The following video shows a real life example of a moral hazard.:





-Navya Sonthalia