Tuesday, January 14, 2014

Moral hazard

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.

In insurance, the chance that the insured will be more careless and take greater risks because he or she is protected, thus increasing the potential of claims on the provider. The concept can be extended to any contract (such as a loan from the IMF to a country in financial crisis) that by its existence could prompt a signatory to take unnecessary risks.

Moral hazard arises when a contract or financial arrangement creates incentives for the parties involved to behave against the interest of others.

There are concerns that some individuals that take out large insurance policies to cover specific risks are likely to claim against such policies. There are also concerns that some borrowers that take on loans at very high interest rates are likely to have incentives to default.

Insurance firms and banks use screening techniques to try and identify such customers and monitor their behavior.

Moral hazard occurs once a contract or financial arrangement has been agreed upon.

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