Reviewed by Jan 05, 2021| Updated on
Moral hazard is the risk associated with entering into a contract. The risk arises from one of the parties trying to take advantage of the risks associated by providing misleading information about its assets, liabilities, or credit capacity. The risks in the contract provide an opportunity to benefit by acting contrary to the principles laid down in the contract.
Moral hazard arises in a contract involving a risky event where one party is protected from the risk knowing that another person would bear the cost associated with the risk. Moral hazard arises commonly in contracts which are insured against risks.
Moral hazard generally arises in case of lending and insurance business, and employer-employee relations. In the case of the lending business, moral hazard is the risk that a borrower of money could engage in activities that do not match the purpose of the loan and would hence make the borrower less likely to pay back a loan.
An example of moral hazard was in the 2008 financial crisis, where homeowners walked away from the repayment of the mortgage. In this case, the loans were sold by the lending institutions to investors, thus shifting the risks on investors.
Borrowers who struggled to make the mortgage repayments also faced a moral hazard whether to try to repay the loan or walk away from the loan in the face of the falling property prices.
The decision of a person who is a party to a contract is based on the benefits of acting against the terms of the contract and not on what is considered right. Hence, the hazard is called a moral hazard.
Moral hazard in a contract is related to the assumption of risk and information asymmetry as between the contracting parties. Individuals or entities alter their risk-taking behaviour depending on the risks of their actions assumed by others.