Moral Hazard
Written by Studio AM.
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When protection shifts some consequences of a risky choice to someone else, it can change the incentive to take care. Economists call this moral hazard, when that protection encourages greater risk-taking or less effort to prevent a loss.
Insurance is the classic case. A person with generous theft insurance may lock their door a little less carefully, because the insurer would cover part of the financial loss. The person still has reasons to avoid theft, including inconvenience and the loss of personal belongings. None of this requires dishonesty. The incentive simply shifts: one financial reason for caution becomes weaker, even though other reasons remain.
The effect scales up. A bank that expects to be rescued if its gambles fail has reason to gamble more, if decision-makers expect to keep benefits while others absorb much of the loss. This is why a promise of protection can, perversely, produce the very recklessness it was meant to guard against. The effect is possible, not inevitable; supervision and the terms of protection also matter.
The remedy is not to abolish protection, which does real good, but to keep some of the consequence attached to the one who decides. Some insurance policies use a deductible, the amount the insured pays toward a covered loss. Other arrangements use monitoring or limits on risky activity. The general principle is simple: design protection so that it remains useful without removing important reasons for caution.
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Questions
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Question 1 of 4
What is the passage mainly about?
The answer is A: Protection can change incentives, so its terms should preserve reasons for caution.
The passage describes a possible change in incentives and ways to retain caution while preserving useful protection.
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Question 2 of 4
What does insurance use to keep the insured feeling part of the loss?
The answer is B: A deductible
The text says 'Insurance uses a deductible, so the insured still feels part of the loss.'
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Question 3 of 4
The bank example suggests that a promise of rescue can:
The answer is A: Encourage greater risk-taking when decision-makers expect others to absorb losses.
An expected rescue can weaken an incentive for caution if benefits remain private while much of the loss falls elsewhere.
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Question 4 of 4
What does 'perversely' mean in this passage?
The answer is A: opposite to the intended result
Protection meant to reduce risk instead produces it - a backward, opposite-to-intent result.
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