Moral Hazard: Building Fortune While Making Everyone Fail

Moral hazards are situations when we are incentivized to expose ourselves to risk because we do not bear the full costs associated with that risk. Think: playing with other people’s money. Should things go wrong, we are not hurt. Another instance is an insured corporation: it takes on higher risk knowing that its insurance will cover the associated costs. A moral hazard is thus when risk-taking behavior change to the detriment of the party that bears the cost.

They can happen for various reasons, though commonly they are observed under information asymmetry. The risk-taking party knows more about its intentions than the party paying for the consequences. One person acts on behalf of another, and the former risks the funds of the latter. Economist Paul Krugman summed moral hazard up as any situation “in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly.” It often occurs with borrowing. Borrowers don’t act prudently when they invest or spend funds, which is why credit card companies have to limit the amount debtors can spend because, without such limits, borrowers would spend the money recklessly and default.

The key concept is that risk is partially transferred or one party is shielded from the full cost of their actions, prompting them to take on riskier behavior. The presence of safety — insurance, government bailouts, guarantees — can inadvertently encourage risky behavior. Insured drivers drive more recklessly because they know the insurance company will cover damages. Banks engage in riskier lending if it believes government bailouts will rescue it in case of failure. Company managers make more aggressive business moves that benefit them personally, even if those moves put the firm at risk. Patients with comprehensive insurance overuse medical services because they don’t pay the full cost. It’s morally screwed, and that’s where the name comes from.

Real-world examples of moral hazards:

• Insurance: drivers with full coverage are less careful because their financial risk is reduced; insured individuals schedule doctor visits or tests more than necessary since they don’t face the full out-of-pocket costs.

• Banking: financial institutions engage in risky investments since they expect government bailouts during financial crises, as was seen in 2008; when companies are guaranteed by external parties, they undertake riskier projects knowing the losses will be covered.

• Organizational Behavior: managers take excessive risks if their personal incentives (bonuses, promotions) are tied to short-term gains while long-term consequences are borne by the company; government programs can sometimes result in reduced incentives for people to seek employment.

How you might use moral hazard as a mental model: (1) identify risk-shielding — find where one party’s risk is absorbed by another, and ask “Who bears the cost if this goes wrong?”; (2) look at how incentives are set up — consider whether a safety net can inadvertently encourage riskier behavior, and ask “Do they align the interests of all the parties involved?”; (3) develop anti-moral-hazard measures — ensure that those taking the risks have skin in the game; (4) monitor behavior over time — track if the presence of protection results in a decline of cautious behavior and adjust policies based on how much risk you want your subordinates to take.

Try these tactics to mitigate moral hazards: (1) risk sharing — adjust contracts so that the party taking the risk bears the cost, like deductibles in insurance policies so that insured parties don’t act carelessly; (2) align incentives — structure rewards and penalties so that all parties act responsible, like performance-based compensation that rewards company-wide success rather than divisional gains; (3) oversight mechanisms — look for and correct risky behavior before it becomes problematic. Essentially, you have to make the risk-taker feel responsible.