Understanding the Difference Between Moral Hazard and Adverse Selection

Reviewed by Robert C. KellyFact checked by Jiwon MaReviewed by Robert C. KellyFact checked by Jiwon Ma

Moral hazard and adverse selection both describe situations where one party is at a disadvantage as a result of another party’s behavior.

Moral hazard occurs when there exists asymmetric information between two parties, and the behavior of one party changes after an agreement is struck between them. Adverse selection occurs in transactions where one party has more information than the other about product quality and exploits it.

Key Takeaways

• Moral hazard and adverse selection are both terms used in economics, risk management, and insurance to describe situations where one party is at a disadvantage to another.
• Moral hazard occurs when one party entering into the agreement provides misleading information or changes their behavior after the agreement has been made because they believe that they won’t face any consequences for doing so.
• Adverse selection occurs in transactions where one party has more information about product quality than the other and takes advantage of this discrepancy.

Moral Hazard

Moral hazard occurs when one party entering into an agreement provides misleading information, or when they change their behavior after an agreement has been made. This occurs when a person or an entity does not bear the full cost of risk, which can lead them to increase their exposure to it. Often, this decision is made to obtain higher levels of benefit.

Moral hazard arises in instances when one party provides false information about their assets, liabilities, or credit capacity. It can occur in various settings, including banking, the insurance industry, and the workplace.

Example of Moral Hazard

Assume a homeowner does not have homeowner’s insurance or flood insurance but lives in a flood zone. The homeowner is very careful and subscribes to a home security system that helps prevent burglaries. When there are storms, they prepare for floods by clearing the drains and moving furniture to prevent damage.

However, the homeowner is tired of always having to worry about potential burglaries and preparing for floods, so they purchase home and flood insurance. After their house is insured, their behavior changes. They cancel their home security system subscription and they do less to prepare for potential flooding. The insurance company is now at a greater risk of having a claim filed against them as the result of damage from flooding or loss of property. This is an example of moral hazard.

History of Moral Hazard

According to research by economists Allard E. Dembe at Ohio State University and Leslie I. Boden at Boston University, the term “moral hazard” was widely used by insurance agents in England. Although early usage of the term implied fraudulent and immoral behavior, at times the word “moral” has also been used to simply refer to subjective behavior in the field of mathematics, so the ethical implications of the term are not fixed. In the 1960s, moral hazard became a subject of study again among economists. At this time, rather than serve as a description of the morals of involved parties, 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 in a deal has more accurate information than the other. The party with less information is at a disadvantage to the party with more information. This asymmetry causes a lack of efficiency in the price and the number of goods and services provided. Most information in a market economy is transferred through prices, which means that adverse selection tends to result from ineffective price signals.

Example of Adverse Selection

For example, assume there are two sets of people in the population: those who smoke and do not exercise, and those who do not smoke and who exercise. It is common knowledge that those who smoke and don’t exercise have shorter life expectancies than those who don’t smoke and choose to exercise. Suppose there are two individuals who are looking to buy life insurance, one who smokes and does not exercise, and one who doesn’t smoke and exercises daily. The insurance company, without further information, cannot differentiate between the individual who smokes and doesn’t exercise and the other person.

The insurance company asks the individuals to fill out questionnaires to identify themselves. However, the individual that smokes and doesn’t exercise knows that by answering truthfully, they will incur higher insurance premiums. This individual decides to lie and says they don’t smoke and exercise daily. This leads to adverse selection; the life insurance company will charge the same premium to both individuals. However, insurance is more valuable to the non-exercising smoker than the exercising non-smoker. The non-exercising smoker will require more health insurance and will ultimately benefit from the lower premium.

Insurance companies reduce exposure to large claims by limiting their coverage or raising premiums. Insurance companies attempt to mitigate the potential for adverse selection by identifying groups of people who are more at 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 to give them insurance or how much premiums to charge them. Underwriters typically evaluate any issue that may impact an applicant’s health, including but not limited to an applicant’s height, weight, medical history, family history, occupation, hobbies, driving record, and smoking habits.

What Is An Example of Adverse Selection?

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

What Is the Difference Between a Moral Hazard and a Morale Hazard?

In an insurance context, moral hazard is sometimes distinguished from a closely related idea known as “morale hazard.” Both terms describe changes in a party’s behavior after they have obtained insurance. However, moral hazard refers to conscious risk-taking that the party might engage in now that they no longer have to bear risk. In contrast, morale hazard refers to a a subconscious level of indifference to risk, rather than active choices to expose oneself to it.

What Are the Two Types of Moral Hazard?

Moral hazard can be broken into two types based on the timing of one party’s risk-taking behavior. Ex-ante moral hazard occurs when a party engages in risky actions before a specific outcome occurs, whereas ex-post moral hazard occurs after.

Take the classic health insurance example: Say an individual obtains health insurance and subsequently begins to engage in risky activities and behaviors, knowing that any potential health problem won’t incur costs on them. This is a form of ex-ante moral hazard, as the risky behavior is taking place before any event that would trigger an insurance payout has occurred.

On the other hand, ex-post moral hazard would occur if the party got into an accident but exaggerated the costs associated with recovery or opted for unnecessary medical treatments to their own benefit.

The Bottom Line

Both moral hazard and adverse selection describe situations with undesired outcomes due to information asymmetry between two parties. The main difference is when it occurs. In a moral hazard situation, the change in the behavior of one party occurs after the agreement has been made. However, in adverse selection, there is a lack of symmetric information prior to when the contract or deal is agreed upon.

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