Moral Hazard

Insurance is a useful, sometimes indispensible, risk management tool. Whether that risk is loss of income, or damage to a vehicle, or the loss of one's life, insurance is a way to mitigate a risk. Moral Hazard is one component of that on-going risk assessment.

Moral Hazard Defined

We recently discussed "insurable interest" as a part of the risk assessment process. But insurable interest is only one side of a coin: the other is called "moral hazard." Moral hazard is the "risk that a party to a transaction has not entered into the contract in good faith, has provided misleading information about its assets, liabilities or credit capacity, or has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles."Moral Hazard underpins all insurance contracts; homeowners insurers, for example, have strict rules about how much homes can be insured for, and what condition they must be in. They don't want to tempt insured's into a literal "fire sale." And life insurers are loathe to make their insured's "easy targets." Both of these eventualities would be "against the public interest."

Moral Hazard Applied

Let's take a look at some examples of moral hazard from different areas of the insurance business:Several years ago, a pair of Los Angeles women bought insurance policies on the lives of several homeless men, then arranged fatal hit-and-run "accidents" so that they could collect the death benefits. There was no previous or financial relationship between the men and the perpetrators; it's unclear how these policies got past underwriting. But it's an egregious example of moral hazard: these women had every incentive to kill these homeless men, but no insurable interest in their lives.Or consider that the neighborhood in which you live has been steadily declining, and you're now "upside down" on your mortgage. The house, which you've insured for $100,00 is currently worth a mere $40,000 on the market. Now if you only had a match...

What's a Viatical?

Perhaps the most well-known example of moral hazard is viatication. Simply put, a viatical contract is one where an insured who believes that he is not long for this world, and has no real need for his life insurance policy ("you can't take it with you") will contract with a third party who arranges the sale of the policy to an investor (or group of investors). They agree to pre-pay a portion of the death benefit upfront, and then collect the full face amount when the insured dies. Typically, the shorter the expected life-span, the higher the percentage of that face amount is pre-paid.The moral hazard here is obvious: the sooner the insured dies, the sooner the investor recoups his investment. These plans have lost favor over the years as insurance companies have offered accelerated benefits riders to their insureds, who can then access at least a part of the death benefit without having to completely give up the coverage.

The reason Moral Hazard plays such a key role in the insurance underwriting process is that it accounts for human nature. That is, some people will try to game, or cheat, the system, and thus cause problems for everyone else with legitimate needs and concerns. And encouraging, let alone rewarding, morally hazardous behavior makes it that much more difficult for the public at large to find appropriate insurance products at affordable prices.

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